Problem 9-10 Cost of Equity The earnings, dividends, and common stock price of S
ID: 2712951 • Letter: P
Question
Problem 9-10
Cost of Equity
The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 4% per year in the future. Shelby's common stock sells for $26.25 per share, its last dividend was $1.50, and the company will pay a dividend of $1.56 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 1.9, the risk-free rate is 5%, 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 11%, 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
We have:
D1= 1.56
G= 4%
P = 26.25
Ke using DDM = D1/P + g
=1.56/26.25 + 0.04
= 9.94%
Beta =1.90
Rf = 5%
Rm=12%
Ke using CAPM = Rf + (Rm-Rf) xbeta
=5% +(12%-5%)X1.90
= 18.30%
MRP = 3%
Bond return = 11%
Ke = 11%+3% =14%
We need to calculate the average of Kes under all the approaches .
Average Ke =9.94% +18.30% +14%)/3
=14.08%