Quantitative Problem: Barton Industries estimates its cost of common equity by u

Question

Quantitative Problem: Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, D1, to be $1.60 and it expects dividends to grow at a constant rate g = 4.1%. The firm's current common stock price, P0, is $30.00. The current risk-free rate, rRF, = 4.3%; the market risk premium, RPM, = 5.6%, and the firm's stock has a current beta, b, = 1.2. Assume that the firm's cost of debt, rd, is 6.63%. The firm uses a 3.6% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places.

Explanation / Answer

Using CAPM, Cost of equity = Rf + beta x MRP = 4.3% + 1.2 x 5.6% = 11.02%

Using Bond yield plus risk premium, Cost of equity = Cost of debt + Premium = 6.63% + 3.6% = 10.23%

Using DCF, Cost of equity = D1 / P + g = 1.6 / 30 + 4.1% = 9.43%

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