Question

termediate Prablems COST OF COMMON EQUITY The future earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow 7% per year. Carpetto's common stock currently sells for $23.00 per share; its last dividend was $2.00; and it will pay a $2.14 dividend at the end of the current year. a. Using the DCF approach, what is its cost of common equity? b. If the firm's beta is 1.6, the risk-free rate is 9%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? If the firm's bonds earn a return of 12%, 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. 10-6 d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Evanec Company's

Answer 1

a). Cost of common equity = [D1 / P0] + g

= [$2.14 / $23] + 0.07 = 0.0930 + 0.07 = 0.1630, or 16.30%

b). Cost of common equity = Risk-free Rate + [Beta * (Expected Market Return - Risk-free Rate)]

= 9% + [1.6 * (13% - 9%)] = 9% + [1.6 * 4%] = 9% + 6.4% = 15.4%

c). Lets assume the range of risk premium is 3%-5%

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

Cost of common equity = Bond's Yield + Risk Premium = 12% + 4% = 16%

d). Cost of Common Equity = Average of cost of common equity from all methods

= [16.3% + 15.4% + 16%] / 3 = 47.7% / 3 = 15.9%