Question

Cost of Equity The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 4% per year in the future. Shelby's common stock sells for $25.00 per share, its last dividend was $2.50, and the company will pay a dividend of $2.60 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 2.2, the risk-free rate is 5%, and the expected return on the market is 12%, 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 9%, 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) Calculate the cost of equity using discounted cash flow approach as follows: Expected dividend Current price Cost of equity +Growth rate $2.60 +0.04 $25 0.144(or)14.4% Therefore, the cost of equity using discounted cash flow approach 14.40% b) Calculate the cost equity based on CAPM as follows: Cost of equity Risk-free rate+(Bx[Market return Risk-free rate] -5.0%+(2.2 x12.0%-5.0%|) -5.0 % +15.4% -20.4 % Therefore, the cost equity based on CAPM is 20.40%.

c) Suggested appropriate risk premium range is 3% to 5%. Midpoint of 3% to 5% range is 4%. Hence, considerable risk premium is 4%. Calculate the cost of equity using over-own-bond-yield-plus judgmental-risk-premium approach as follows: Cost of equity Bonds' yield+Risk premium 9%+4% 13% Therefore, the cost equity using over-own-bond-yield-plus-judgmental risk-premium approach is 13.00% d) Best estimate of cost of equity (is equal to average of cost of equity under three approaches as all values approach equally) Cost of equityUnder Discounted cash fow +Cost of equity Under CAPM +Cost of equitynder oer-wn-bond-yield plus-jud gmental-risk-premium Cost of equity 3 14.40% 20.40% +13.00 % 3 - 15.93 % Therefore, best estimate of cost of equity is 15.93%.