Question

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

Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.
%.......

If the firm's beta is 2.1, the risk-free rate is 8%, 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.
%......

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 rsusing 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).
%.......

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

Formula sheet

A	B	C	D	E	F	G	H	I
2
3		a)
4		As per dividend growth model, Price of share is the present value of all future dividends discounted at cost of equity.
5		Current Price of Share (P)	=Div1/(r-g)
6		Where Div1 is the dividend to be paid at the end year, r is cost of equity and g is perpetual growth rate of dividend.
7
8		Cost of equity can be calculated as below:
9		Cost of equity, r(E) = (Div1/P)+g
10
11		Given the following data:
12		Dividend (Div1)	2.06
13		Price (P)	21
14		Growth rate (g)	0.03
15
16		From Dividend growth model,
17		r(E) = (Div1/P)+g
18		Cost of equity=	=(D12/D13)+D14	=(D12/D13)+D14
19
20		Hence cost of equity is	=D18
21
22		b)
23
24		Calculation of Cost of Equity of portfolio D as per CAPM:
25		As Per CAPM, Cost of Equity can be calculated as
26		r(E) = rf + ?*(rm-rf)
27		Using the Following data
28		Beta (?)	2.1
29		Risk free rate ( rf )	0.08
30		Market Return (rm)	0.14
31
32		Cost of Equity can be calculated as follows:
33		Cost of Equity	= rf + ?*(rm-rf)
34			=D29+D28*(D30-D29)	=D29+D28*(D30-D29)
35
36		Hence Cost of Equity as per CAPM is	=D34
37
38		c)
39		Using Bond Yield Plus judgemental risk premium approach,
40		Cost of Equity = Yield of Company's Bond + Judgemental risk permium
41
42		Using the following data:
43		Yield on Company's Bond	0.12
44		Market Risk Premium	0.04	(Average of 3% and 5%)
45
46		Cost of Equity	= Yield of Company's Bond + Judgemental risk permium
47			=D43+D44	=D43+D44
48
49		Hence Cost of Equity is	=D47
50
51		b)
52		Method	Cost of Equiy
53		Dividend Growth	=D20
54		CAPM	=D36
55		Bond Yield Plus judgemental risk premium approach	=D49
56		Average	=AVERAGE(D53:D55)
57
58		Hence cost of Equity is	=D56
59