Question

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 5% per year in the future. Shelby's common stock sells for $20.50 per share, its last dividend was $1.80, and the company will pay a dividend of $1.89 at the end of the current year.

Problem 9-10 Cost of Equity The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 5% per year in the future. Shelby's common stock sells for $20.50 per share, its last dividend was $1.80, and the company will pay a dividend of $1.89 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 1.0, the risk-free rate is 7%, and the expected return on the market is 13%, then what would be the firm's cost of equity based on the CAPM approach? Round your answer to two decimal places. % 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) Cost of Equity = Dividend at year end/Price + Growth =1.89/20.50 +5%=14.2195% or 14.22%

b) Cost of equity using CAPM = Risk Free Rate + beta *(Market Return - Risk Free Rate) = 7% +1(13%-7%) = 13.00%

c) Risk Premium in DCF method = 14.2195% - 7% = 7.2195%
Risk Premium in CAPM method = 13% - 7% = 6%
Average risk premium =(7.2195%+6%)/2 = 6.6098%
Cost of equity =Risk Free Rate+Risk Premium =8%+6.6098% =14.6098% or 13.61%

d) Shelby's inc Cost of common equity = (14.2195%+13.00%+14.6098%)/3 = 13.94%