Question

Problem 10-6 Cost of Common Equity The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6 % per year. Callahan's common stock currently sells for $22.75 per share; its last dividend was $2.00; and it will pay a $2.12 dividend at the end of the current year. a. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations. b. If the firm's beta is 0.60, the risk-free rate is 5 %, 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. c. If the firm's bonds earn a return of 99%, based on the bond-yield-plus-risk-premium approach, what will be r? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places. d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations % Check My Work (No more tries available) OO

Answer 1

a). Cost of equity (using DDM) = (D1/P0) + g where D1 = 2.12; P0 = 22.75 and g = 6%

= (2.12/22.75) + 6% = 15.32%

b). Cost of equity (using CAPM) = risk-free rate + beta*(market return - risk-free rate)

= 5% + 0.60*(13%-5%) = 9.80%

c). Cost of equity = Bond yield + mid-point of risk premium range

If the range is from 3% to 5% then the mid-point is 4%

Cost of equity = 9% + 4% = 13.00% (Note: the risk premium range is not given in the question so the generally used range is taken. If the range is different then answers to (c) & (d) will differ from the given ones.)

d). Equal confidence means equal weights so cost of equity will be the average of the three

= (15.32%+9.80%+13%)/3 = 19.06%