Question

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 3% per year. Callahan's common stock currently sells for $20.00 per share; its last dividend was $2.00; and it will pay a $2.06 dividend at the end of the current year.

1. Using the DCF approach, what is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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2. If the firm's beta is 1.8, the risk-free rate is 3%, 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.

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3. If the firm's bonds earn a return of 12%, based on the bond-yield-plus-risk-premium approach, what will be r_s? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.

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4. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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Answer 1

(a): Here g = 3%, P0 = $20, D0 = $2 and D1 = $2.06

We know that P0 = D1/r-g

Thus 20 = 2.06/r-3%

Or r-3% = 10.3%

Or r = 13.30%

(b): CAPM: cost of equity = risk free rate + beta*(market return – risk free rate)

= 3% + 1.8*(13%-3%)

= 21.00%

(c ): The suggested appropriate risk premium range in the Brigham and Houston(2013) textbook is from 3% to 5%.

The mid-point of this range would, therefore, be a risk premium (RP) of 4%.

Cost of common equity (rS) = 0.12 + 0.04 = 0.16

= 16.00%

(d): cost of common equity = (13.30% + 21.00% + 16.00%)/3

= 16.77%