Question

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 8% per year in the future. Shelby's common stock sells for $27.00 per share, its last dividend was $2.50, and the company will pay a dividend of $2.70 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.
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2. If the firm's beta is 1.1, the risk-free rate is 4%, and the expected return on the market is 12%, then what would be the firm's cost of equity based on the CAPM approach? Round your answer to two decimal places.
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3. If the firm's bonds earn a return of 10%, then what would be your estimate of r_s using the own-bond-yield-plus-judgmental-risk-premium approach? (Hint: Use the mid-point of the risk premium range.) Round your answer to two decimal places.
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4. On the basis of the results of parts a–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. The cost is computed as follows:

= (Dividend to be paid / current price) + growth rate

= ($ 2.70 / $ 27) + 8%

= 18%

b. The cost is computed as follows:

= Risk free rate + Beta x (return on market - risk free rate)

= 4% + 1.1 x (0.12 - 0.04)

= 12.80%

c. The cost is computed as follows:

= 10% + 4% (Since the range of risk premium normally fluctuates between 3% to 5%, therefore 4% has been assumed as  midpoint )

= 14%

d. The cost will be as follows:

= (18% + 12.8% + 14%) / 3

= 14.93%