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 $30.00 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 1.5, the risk-free rate is 8%, and the expected return on the market is 14%, 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

Requirement (a) – Cost of Common Equity using DCF Approach

Dividend in year 1 (D1) = $2.60 per share

Current selling price per share (P0) = $30.00 per share

Dividend growth Rate (g) = 4.00% per year

Therefore, the Cost of Common Equity = [D1 / P0] + g

= [$2.60 / $30.00] + 0.04

= 0.0867 + 0.04

= 0.1267 or

= 12.67%

Requirement (b) – Cost of Common Equity using CAPM Approach

Cost of Common Equity using CAPM Approach = Risk-free Rate + Beta(Market Rate of Return – Risk-free Rate)

= Rf + Beta[Rm – Rf]

= 8.00% + 1.50[14.00% - 8.00%]

= 8.00% + [1.50 x 6.00%]

= 8.00% + 9.00%

= 17.00%

Requirement (c) – Cost of Common Equity Bond Yield Risk Premium Approach

The appropriate risk premium discussed in section 10-5 is from 3% to 5%. Therefore, the mid-point of the range is 4%

Therefore, The Cost of Common Equity Bond Yield Risk Premium Approach = Return of the Bond + Mid-point of the range

= 9.00% + 4.00%

= 13.00%

Requirement (d) – Shelby’s Cost of equity

Using Equal Confidence, the cost of common equity would be the average of the cost of common equity calculated under the above 3 alternatives,

Cost of Common Equity = [12.67% + 17.00% + 13.00%] / 3

= 42.67% / 3

= 14.22%