Question

You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

a. 1.13%

b. 1.50%

c. 1.88%

d. 2.34%

e. 2.58%

Answer 1

Cost of Equity is as follows:

1.Debt cost plus risk premium approach = Cost + debt + risk premium

= 7% + 4%

= 11%

2.CAPM = Risk free rate + beta*Market risk premium

= 5% + 1.25*6%

= 12.5%

3.DDM

P0 = D1/(Cost – g)

35 = 1.2/(Cost – 8%)

Cost = 11.43%

Hence, difference between highest and lowest is 12.5%-11%

= 1.5%

i.e. b