Cost of Equity The earnings, dividends, and common stock price of Shelby Inc. ar
ID: 2762762 • 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 $26.00 per share, its last dividend was $2.00, and the company will pay a dividend of $2.10 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 1.2, the risk-free rate is 6%, and the expected return on the market is 14%, 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 10%, 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) The cost of equity = D1/P0 + g, where D1 is the next expected dividend, P0 is the current price and g is the growth rate. Substituting values we have
cost of equity = (2.1/26) + 0.05 = 0.1308 = 13.08%
b) As per CAPM, cost of equity = Rf + B(Rm-Rf), where Rf is risk free rate, Rm is market return and B is th beta of the stock.
so cost of equity = 6 + 1.2(14-6) = 15.6%
c) Using mid point of the risk premium range, cost of equity = 10 + 4 = 14%
d) As all the above three methods are equally valued, the average values obtained by the three methods can be taken as the final estimate.
cost of equity = (13.08+15.6+14)/3 = 14.23%