Cost of Equity The earnings, dividends, and common stock price of Shelby Inc. ar
ID: 2754270 • Letter: C
Question
Cost of Equity
The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 5% per year in the future. Shelby's common stock sells for $22.00 per share, its last dividend was $2.40, and the company will pay a dividend of $2.52 at the end of the current year.
a) Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places. _____%
b) If the firm's beta is 2.0, 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.
______%
c) If the firm's bonds earn a return of 8%, 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).
_____%
d) 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
A)
Price = recent dividend* ( 1 + growth rate )/( cost of equity - growth rate)
22 = 2.4 * (1 + .05)/(cost of equity - 0.05)
= 16.45%
B)
expected return = risk-free rate + beta * (expected return on the market - risk-free rate)
= 5 +2*(12-5) = 19%
C)
Cost of equity = bond return + midpoint of market risk premium = 8 +(3+5)/2 = 12%
D) shelby is giving equal weight to all 3 values from above methods
therefore estimated cost of equity = 16.45/3+19/3+12/3 = 15.82%