Question

The earnings, dividends, and stock price of Shelby Inc. are expected to grow at 7% per year in the future. Shelby's common stock sells for $23.50 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 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 0.7, the risk-free rate is 3%, 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. % If the firm's bonds earn a return of 9%, then what would be your estimate of rs 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. % 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

Answer a.

Expected Dividend = $2.14
Current Price = $23.50
Growth Rate = 7%

Cost of Common Equity = Expected Dividend / Current Price + Growth Rate
Cost of Common Equity = $2.14 / $23.50 + 0.07
Cost of Common Equity = 0.0911 + 0.0700
Cost of Common Equity = 0.1611 or 16.11%

Answer b.

Risk-free Rate = 3.00%
Beta = 0.70
Market Return = 12.00%

Cost of Common Equity = Risk-free Rate + Beta * (Market Return - Risk-free Rate)
Cost of Common Equity = 3.00% + 0.70 * (12.00% - 3.00%)
Cost of Common Equity = 3.00% + 0.70 * 9.00%
Cost of Common Equity = 9.30%

Answer c.

Bond Yield = 9.00%

Risk Premium is midpoint of the range of risk premium (assuming 3% to 5%). So, midpoint is 4%

Cost of Common Equity = Bond Yield + Risk Premium
Cost of Common Equity = 9.00% + 4.00%
Cost of Common Equity = 13.00%

Answer d.

Estimated Cost of Common Equity = Average of Cost of Common Equity
Estimated Cost of Common Equity = (36.50% + 11.90% + 16.00%) / 3
Estimated Cost of Common Equity = (16.11% + 9.30% + 13.00%) / 3
Estimated Cost of Common Equity = 12.80%