Question

The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 4% per year in the future. Shelby's common stock sells for $25.50 per share, its last dividend was $2.00, and the company will pay a dividend of $2.08 at the end of the current year.

1. Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.
   %
   
2. If the firm's beta is 1.3, the risk-free rate is 4%, 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.
   %
   
3. If the firm's bonds earn a return of 12%, and analysts estimate the market risk premium is 3 to 5 percent, then what would be your estimate of r_s 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).
   %
   
4. 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. The cost of equity will be as per the discounted cash flow approach :

Re = D1/ Po + g

= $2.08/ $25.5 + 0.04

= 12.16%

b. The cost of equity as per the CAPM model is :

Re = Rf + beta (Rm - Rf)

= 4 + 1.3 * (14 - 4)

= 17%

c. Bond yield plus risk premium approach :

Re = bond yield + risk premium

= 12% + 4%

= 16%

The mid point of 3% and 5% is 4%.

d. The estimate of the cost of equity is :

1/3* 12.16% + 1/3 * 17% + 1/3 * 16%

= 4.0533 % + 5.6667 +5.3333

= 15.05% ( rounded off to two decimal places)