Cost of Common Equity The future earnings, dividends, and common stock price of
ID: 2765917 • Letter: C
Question
Cost of Common Equity
The future earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow 4% per year. Carpetto's common stock currently sells for $22.50 per share; its last dividend was $2.50; and it will pay a $2.60 dividend at the end of the current year.
A. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places.
B. If the firm's beta is 1.90, the risk-free rate is 4%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places
C. If the firm's bonds earn a return of 8%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.
D. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Round your answer to two decimal places
Explanation / Answer
Answer:
Growth Rate (G) = 4% or 0.04
Current Market PRice of Stock (Po) = $22.50
Last Dividend Paid (Do) = $2.50
Expected Dividend (D1) = $2.60
A) Cost of Equity (DCF Approach) = D1 / Po + G = $2.60 / $22.50 + 0.04 = 0.1155 + 0.04 = 0.1555 or 15.55%
B) Cost of Equity (CAPM Approach) = Risk free return + Beta x (Market Return - Risk Free Return)
= 4% + 1.90 (13% - 4%)
= 4% + 17.1%
= 21.10%
C) Cost of Equity (bond-yield-plus-risk-premium approach) = Cost of Debt + Risk Premium in excess of cost of debt
= 8% + Risk Premium in excess of cost of debt
You can add Risk Premium to find out cost of equity..(in the question it is not given)
D) Cost of Equity by using CAPM approach is provide absolute measure of Company's Cost of Equity. Hence cost of common equity = 21.10%
Reason -- DCL Approach is using the assumption of constract growth rate. It ignores market risk or market premium.