Cost of Equity The earnings, dividends, and stock price of Shelby Inc. are expec
ID: 1172114 • Letter: C
Question
Cost of Equity The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby's common stock sells for $22.50 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 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. % If the firm's beta is 1.3, the risk-free rate is 4%, 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. % If the firm's bonds earn a return of 9%, 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
Answer a.
Expected Dividend, D1 = $2.14
Current Price, P0 = $22.50
Growth Rate, g = 7%
Cost of Equity = D1 / P0 + g
Cost of Equity = $2.14 / $22.50 + 0.07
Cost of Equity = 16.51%
Answer b.
Risk-free Rate = 4%
Beta = 1.3
Market Return = 12%
Cost of Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Cost of Equity = 4% + 1.30 * (12% - 4%)
Cost of Equity = 14.40%
Answer c.
Bond Yield = 9%
Risk Premium = 4%
Cost of Equity = Bond Yield + Risk Premium
Cost of Equity = 9% + 4%
Cost of Equity = 13.00%
Answer d.
Estimated Cost of Equity = (16.51% + 14.40% + 13.00%) / 3
Estimated Cost of Equity = 14.64%