Cost of Equity question 9-10 The earnings, dividends and stock price of Shelby I
ID: 2713725 • Letter: C
Question
Cost of Equity question 9-10
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 $23 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.
(a) Using the discounted cash flow approach what is the cost of equity? (Answer is 16.3%-show all work and formulas)
(b) If the firms beta is 1.6, the risk free rate is 9% and the expected return on the market is 13%, then what would be the firm's cost of equity based on the CAPM approach? (answer is 15.4%--show all work and formulas)
(c) if the firm's bonds earn a return of 12% then what would be your estimate of rs using the own bond yeild plus judgement risk premium approach? (Hint use the midpoint of the risk premium range)--(Answer is 16% show all work and formula)
(d) on the basis of the results of parts a through c what would be your estimate of Shelbys cost of equity?
Explanation / Answer
a)
Stock price = D1÷(r-g)
D1 is next expected dividend
r is required return
g is growth rate
a)
$23 = $2.14÷(r-7%)
Cost of equity, r = 16.3%
b)
Expected return = Rf+×Rp
Rf is risk free return
Rp is risk premium
= 9%+1.6×(13%-9%)
= 15.4%
c)
Cost of equity:
= Bond yield+Market risk premium
= 12%+(13%-9%)
= 16%
d)
Estimate of the shelbys cost of equity:
= (16.3%+15.4%+16%)÷3
= 15.9%