Cost of Common Equity The future earnings, dividends, and common stock price of
ID: 2786435 • Letter: C
Question
Cost of Common Equity
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan's common stock currently sells for $22.00 per share; its last dividend was $2.00; and it will pay a $2.12 dividend at the end of the current year.
a. Using the DCF approach, what is its cost of common equity?
b. If the firm's beta is 1.2, the risk-free rate is 6%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach?
c. If the firm's bonds earn a return of 11%, 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.
d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity?
Explanation / Answer
a. Using DCF approach Cost of equity = (D1/P0) + g
Here last dividend was $2, and D1 = 2.14
g = 6%
Current Price of the stock = $22
Cost of equity = 2.14/22 + 6% = 0.09727 + 0.06 = 0.1573 or 15.73%
b) Beta = 1.2
Rf (Risk Free Rate) = 6%
MArket rate of return Rm = 13%
Cost of Equity in CAPM approach = Rf+Beta(Risk Premium)
Risk Premium = Market rate of return - Risk free rate of return
CAPM
Required rate of return = 6% + 1.2 (13%-6%) = 0.06 + 1.2 (0.13-0.06) = 0.06 + 1.2(0.07) = 0.06 + 0.084 = 0.144 or 14.4% (Answer)
c. Bond Yield Plus Risk premium Approach = Bond Yield + Risk Premium = 11% + 7% = 18% (Answer)
d. It is difficult to estimate beta and also growth rate has to be assumed to be constant. Thus bond yield plus risk premium approach to calculate cost of equity.
Cost of Common Equity Ke = D1/P0 + g = 2.14/22 + 6% = 0.1572 or 15.72% (Answer)