Question

The cost of equity using the CAPM approach

1) The current risk-free rate of return (rRFrRF) is 4.67% while the market risk premium is 5.75%. The Jefferson Company has a beta of 0.92. Using the capital asset pricing model (CAPM) approach, Jefferson’s cost of equity is __________ .

The cost of equity using the bond yield plus risk premium approach

2) The Jackson Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company’s cost of internal equity. Jackson’s bonds yield 10.28%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Jackson’s cost of internal equity is:

15.23%

16.75%

19.04%

14.47%

The cost of equity using the discounted cash flow (or dividend growth) approach

3) Tucker Enterprises’s stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project the firm’s growth rate to be constant at 5.72%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Tucker’s cost of internal equity?

10.88%

11.42%

14.69%

10.34%

Estimating growth rates

It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate:

•	Carry forward a historical realized growth rate, and apply it to the future.
•	Locate and apply an expected future growth rate prepared and published by security analysts.
•	Use the retention growth model.

4) Suppose Tucker is currently distributing 75% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 16%. Tucker’s estimated growth rate is__________ %.

Answer 1

Answer 1.

Cost of Equity = Risk-free Rate + Beta * Market Risk Premium
Cost of Equity = 4.67% + 0.92 * 5.75%
Cost of Equity = 4.67% + 5.29%
Cost of Equity = 9.96%

Answer 2.

Cost of Equity = Bond Yield + Risk Premium
Cost of Equity = 10.28% + 4.95%
Cost of Equity = 15.23%

Answer 3.

Cost of Equity = Expected Dividend / Current Price + Growth Rate
Cost of Equity = $2.35 / $45.56 + 0.0572
Cost of Equity = 0.0516 + 0.0572
Cost of Equity = 0.1088 or 10.88%

Answer 4.

Retention Ratio = 1 - Payout Ratio
Retention Ratio = 1 - 0.75
Retention Ratio = 0.25

Growth Rate = Retention Ratio * Return on Equity
Growth Rate = 0.25 * 16.00%
Growth Rate = 4.00%