Question

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 5% per year. Callahan's common stock currently sells for $25.50 per share; its last dividend was $2.40; and it will pay a $2.52 dividend at the end of the current year.

1. Using the DCF approach, what is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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2. If the firm's beta is 1.1, the risk-free rate is 7%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.

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3. If the firm's bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be r_s? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.

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4. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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Answer 1

Answer a.

Expected Dividend = $2.52
Current Price = $25.50
Growth Rate = 5%

Cost of Common Equity = Expected Dividend / Current Price + Growth Rate
Cost of Common Equity = $2.52 / $25.50 + 0.05
Cost of Common Equity = 0.0988 + 0.0500
Cost of Common Equity = 0.1488 or 14.88%

Answer b.

Risk-free Rate = 7.00%
Beta = 1.10
Market Return = 12.00%

Cost of Common Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Cost of Common Equity = 7.00% + 1.10 * (12.00% - 7.00%)
Cost of Common Equity = 7.00% + 1.10 * 5.00%
Cost of Common Equity = 12.50%

Answer c.

Bond Yield = 11.00%

Risk Premium is midpoint of the range of risk premium (assuming 3% to 5%). So, midpoint is 4%

Cost of Common Equity = Bond Yield + Risk Premium
Cost of Common Equity = 11.00% + 4.00%
Cost of Common Equity = 15.00%

Answer d.

Estimated Cost of Common Equity = Average of Cost of Common Equity
Estimated Cost of Common Equity = (14.88% + 12.50% + 15.00%) / 3
Estimated Cost of Common Equity = 42.38% / 3
Estimated Cost of Common Equity = 14.13%