Question

Problem 9-10 Cost of Equity The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby's common stock sells for $20.00 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year.

a) Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.

b)If the firm's beta is 1.7, the risk-free rate is 5%, and the expected return on the market is 14%, then what would be the firm's cost of equity based on the CAPM approach?

(c)If the firm's bonds earn a return of 8%, then what would be your estimate of rs using the over-own-bond-yield-plus-judgmental-risk-premium approach? Round your answer to two decimal places. (Hint: Use the midpoint of the risk premium range.)

(d)On the basis of the results of parts a through c, what would be your estimate of Shelby's cost of equity? Assume Shelby values each approach equally. Round your answer to two decimal places.

Answer 1

a. As per discount cash flow, cost of equity = D1/P0 + g where D1 is the next dividend = 2.14, P0 = current stock price = $20 and g = 7% =0.07

Cost of equity = 2.14/20 + 0.07 = 0.177 = 17.7%

b. Cost of equity based on CAPM = rf +beta*(rm-rf) where rf = risk free rate = 5%, rm = market return = 14% and beta =1.7

Cost of equity = 5 +1.7*(14-5) = 5+1.7*9 = 20.3%

c. Rsik premium range is between 5 and 14. Risk premium range is 5,6,7,8,9,10,11,12,13,14. So mid point of this range = (9+10)/2 = 9.5%

Cost of equity by using  over-own-bond-yield-plus-judgmental-risk-premium = Bond Yield + Risk premium = 8% +9.5% = 17.50%

d. Overall cost of equity using equal weights = 1/3*17.7+1/3*20.3+1/3*17 = 18.50%