Question

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 3% per year. Callahan's common stock currently sells for $21.00 per share; its last dividend was $2.00; and it will pay a $2.06 dividend at the end of the current year.

1. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
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2. 
   
3. If the firm's beta is 1.70, the risk-free rate is 5%, 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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5. If the firm's bonds earn a return of 12%, 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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7. 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

Answer :

(a.) Cost of Equity = (Expected Dividend / Current Price ) + growth rate

= (2.06 / 21) + 0.03

= 12.81%

(b.) Cost of equity = Risk free rate + Beta * (Return from Market - Risk free rate)

= 5% + 1.70 (12% - 5%)

= 16.9%

(c.) Calculation of rs using the own bond yield plus judgement risk premium approach :

Cost of Equity = Bond Yield + Risk Premium

Bond Yield = 12%

Risk Premium = Return from Market - Risk free rate

= 12% - 5%

= 7%

Cost of Equity = 12% + 7%

= 21%

Alternatively if assuming the range of risk premium from 3% to 5%.

Risk Premium = [3% + 5%] / 2

= 8% / 2

= 4%

Cost of Equity will become 12% + 4 % = 16%

Note : For c part fill as per the requirement.

(d.) Cost of Equity is the average of the above cost of equity calculated in above parts .Taking (c.) part as taken as 21%:

Cost of Equity = (12.81% + 16.9% + 21%) / 3

= 16.90%

Cost of Equity is the average of the above cost of equity calculated in above parts .Taking (c.) part as taken as 16%:

Cost of Equity = (12.81% + 16.9% + 16%) / 3

= 15.24%