Problem 11-10 Cost of Equity The earnings, dividends, and common stock price of

Question

Problem 11-10
Cost of Equity

The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 6% per year in the future. Shelby's common stock sells for $21.75 per share, its last dividend was $2.00, and the company will pay a dividend of $2.12 at the end of the current year.

Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.
{C}%

If the firm's beta is 2.0, the risk-free rate is 3%, and the expected return on the market is 12%, then what would be the firm's cost of equity based on the CAPM approach? Round your answer to two decimal places.
{C}%

If the firm's bonds earn a return of 9%, and analysts estimate the market risk premium is 3 to 5 percent, then what would be your estimate of rs using the over-own-bond-yield-plus-judgmental-risk-premium approach? Round your answer to two decimal places. (Hint: Use the midpoint of the risk premium range).
%____________

On the basis of the results of parts a through c, what would be your estimate of Shelby's cost of equity? Assume Shelby values each approach equally. Round your answer to two decimal places.
%_______

Explanation / Answer

DCF approach:

Cost of equity=Expected dividend/price+growth rate=2.12/21.75+6%=15.747%

CaPM approach:

Cost of equity=risk free+beta*(market return-risk free)=3%+2*(12%-3%)=21%

Bond yield plus risk premium:

Cost of equity=bond yield+(3+5)/2=9%+4%=13%

Overall estimate:

Cost of equity=(15.747%+21%+13%)/3=16.582%

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