Question

4. The future earnings, dividends, and common stock price of Barstool Inc. are expected to grow 2% per year. Barstool’s common stock currently sells for $18.00 per share. Its last dividend was $1.50 and it will pay $1.53 dividend at the end of the current year.

a. Using the DCF approach, what is its cost of common equity?
b. If the beta is 2, the risk free rate is 7%, and the average return on the market is 16%, what is the cost of common equity using CAPM?
c. If the firm’s bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what is return on common equity? Use midpoint of risk premium range discussed in section 10-5.

Answer 1

a). According to the DCF;

kE = [D1 / P0] + g

= [$1.53 / $18] + 0.02 = 0.085 + 0.02 = 0.105, or 10.50%

b). According to the CAPM;

kE = Risk-free Rate + [Beta * (Market Return - Risk-free Rate)]

= 7% + [2 * (16% - 7%)]

= 7% + 18% = 25%

c). Let's assume the range of risk premium is 3% to 5%.

Average Risk Premium = [3% + 5%] / 2 = 8% / 2 = 4%

kE = Bond Yield + Average Risk Premium

= 11% + 4% = 15%