Question

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 $2.00; and it will pay a $2.16 dividend at the end of the current year.

A.

Using the DCF approach, what is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

B.

If the firm's beta is 1.3, the risk-free rate is 7%, 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.

C.

If the firm's bonds earn a return of 11%, 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.

D.

If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

Answer 1

	Given,
	Expected Growth Rate = g = 8% = 0.08
	Current Price of Common Stock = P0 = $24.50
	Last Dividend = D0 = $2
	Dividend at the end of Current Year = D1 = $2.16
a)	Using DCF Approach,
	Cost of Common Equity = (D1 / P0) + g
			= ($2.16 / $24.50) + 0.08
			= 0.0882 + 0.08
			= 0.1682
			i.e. 16.82%
b)	Using CAPM Approach,
	Cost of Common Equity = Rf + β(Rm - Rf)
	Where,
	Rf = Risk Free Rate = 7%
	β = Beta = 1.3
	Rm = Average Return on the Market = 13%
	So,
	Cost of Common Equity = Rf + β(Rm - Rf)
			= 7% + 1.3(13% - 7%)
			= 7% + 1.3(6%)
			= 7% + 7.8%
			= 14.80%
c)	Using bond-yield-plus-risk-premium approach
	Cost of Common Equity = Bond Yield + Risk Premium
			= Bond Yield + (Average Return on market - Risk Free Rate)
			= 11% + (13% - 7%)
			= 11% + 6%
			= 17%
	(Please note that as range of risk premium is not given, we take Market Risk
	Premium.)
d)	It states that equal confidence in the inputs used for the three approaches,
	it means equal weights are given to all methods.
	So,
	Cost of Common Equity = 16.82% * 1/3 + 14.80% * 1/3 + 17% * 1/3
			= 5.61% + 4.93% + 5.67%
			= 16.21%