Question

Cost of Equity

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 5% per year in the future. Shelby's common stock sells for $22.50 per share, its last dividend was $1.60, and the company will pay a dividend of $1.68 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 2.2, the risk-free rate is 6%, 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%, 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) Cost of Equity = Dividend at year end/Price + Growth =1.68/22.50 +5%=12.4667% or 12.47%

b) Cost of equity using CAPM = Risk Free Rate + beta *(Market Return - Risk Free Rate) =6%+2.2*(14%-6%) = 23.60%

c) . As per the book the midpoint is 4% (Range is 3%-5%)
Cost of equity =Risk Free Rate+Risk Premium =12%+4% =16%

d) Shelby's inc Cost of common equity =(12.4667%+23.60%+16%)/3 = 17.36%