Question

Cost of Common Equity

The future earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow 4% per year. Carpetto's common stock currently sells for $25.50 per share; its last dividend was $2.00; and it will pay a $2.08 dividend at the end of the current year.

1. 
   
2. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places.
   %
3. 
   
4. If the firm's beta is 1.30, the risk-free rate is 3%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
   %
5. 
   
6. If the firm's bonds earn a return of 9%, 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.
   %
7. 
   
8. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Round your answer to two decimal places.
   

Answer 1

Answer a.

Cost of Common Equity = Expected Dividend / Current Price + Growth Rate
Cost of Common Equity = $2.08 / $25.50 + 0.04
Cost of Common Equity = 0.0816 + 0.0400
Cost of Common Equity = 0.1216 or 12.16%

Answer b.

Cost of Common Equity = Risk-free Rate + Beta * (Return on Market - Risk-free Rate)
Cost of Common Equity = 3.00% + 1.30 * (12.00% - 3.00%)
Cost of Common Equity = 3.00% + 1.30 * 9.00%
Cost of Common Equity = 14.70%

Answer c.

Risk premium range is 3.00% to 5.00%. Midpoint of risk premium range is 4.00%

Cost of Common Equity = Bond Yield + Risk Premium
Cost of Common Equity = 9.00% + 4.00%
Cost of Common Equity = 13.00%

Answer d.

Estimated Cost of Common Equity = Average of Cost of Common Equity under 3 different methods
Estimated Cost of Common Equity = (12.16% + 14.70% + 13.00%) / 3
Estimated Cost of Common Equity = 39.86% / 3
Estimated Cost of Common Equity = 13.29%