Question

6.

COST OF COMMON EQUITY

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 8% per year. Callahan's common stock currently sells for $24.50 per share; its last dividend was $2.50; and it will pay a $2.70 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 1.40, the risk-free rate is 5%, and the average return on the market is 13%, 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

Using the DCF approach, what is its cost of common equity?
Dividend will be paid at end of year	2.70
Divided by: current market price	24.50
	11.02%
Add: growth rate	8.00%
Cost of equity	19.02%
What will be the firm's cost of common equity using the CAPM approach
Cost of equity under CAPM approach = Risk free rate + beta (Market return -Risk free return)
Cost of equity under CAPM approach = 0.05 + 1.4*(0.13-0.05)
Cost of equity under CAPM approach = 0.05 + 1.4*0.08
Cost of equity under CAPM approach = 0.05 +0.112
Cost of equity under CAPM approach = 0.1620 = 16.20%
If the firm's bonds earn a return of 8%, based on the bond-yield-plus-risk-premium approach, what will be rs?
The suggested appropriate risk premium range in the Brigham and Houston (2013) textbook is from 3% to 5%.
Mid-point of above range is 4%
Cost of common equity =0.08+0.04=0.12=12%
If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity
Equal confidence implies equal weighting given to above each Cost of equity.
Firm average cost of equity = ((0.1902+0.162+0.12)/3) =0.1574 = 15.74%