Question

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 7% per year. Callahan's common stock currently sells for $26.25 per share; its last dividend was $2.00; and it will pay a $2.14 dividend at the end of the current year.

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

%

If the firm's beta is 0.80, the risk-free rate is 6%, 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.

%

If the firm's bonds earn a return of 8%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.

%

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

%

Answer 1

a.

Growth rate in dividend = ($2.14 / $2.00) - 1

= 1.07 - 1

= 7%

Growth rate in dividend is 7%.

Cost of equity using DCF = ($2.14 / $26.25) + 7%

= 8.15% + 7%

= 15.15%

Cost of equity using DCF method is 15.15%.

b.

Cost of equity for Allen Company is calculated below using CAPM formula:

Cost of equity = Risk free rate + (Risk Market return – Risk free rate) × Beta

                        = 6% + (12% - 6%) × 0.8

                         = 6% + (6% × 0.8)

                         = 6% + 4.8

                        = 10.8%

Cost of common Equity is 10.8%.

c.

Cost of equity using bond yield plus risk premium is calculated below:

Cost of equity = Bond yield + Risk Premium

                        = 8% + 3%

                        = 11%

Cost of equity using bond yield plus risk premium is 11%.

d.

Average cost of equity = (15.15% + 10.8% + 11%) / 3

= 12.32%.

Average cost of equity is 12.32%.