Question

Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate g = 4.6%. The firm's current common stock price, P0, is $21.00. The current risk-free rate, rRF, = 4.1%; the market risk premium, RPM, = 5.4%, and the firm's stock has a current beta, b, = 1. Assume that the firm's cost of debt, rd, is 8.65%. The firm uses a 3.4% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places.

CAPM cost of equity:

Bond yield plus risk premium:

DCF cost of equity:

What is your best estimate of the firm's cost of equity?

Answer 1

CAPM Cost of Equity = 9.50%

Bond Yield Plus Risk Premium = 12.05%

DCF Cost of Equity = 14.60%

Best estimate of the firm's cost of equity = 12.05%

Calculations

CAPM Cost of Equity

As per Capital Asset Pricing Model [CAPM], The cost of common equity is computed by using the following equation

The Cost of Common Equity = Rf + B[Rm-Rf]

Where; Rf = Risk free rate

B = Average Beta of the stock

[Rm – Rf] = Market Risk premium

In this given question, we have Rf = 4.10%

Market Risk Premium (Rm – Rf) = 5.40%

Average Beta of the stock = 1

After substituting the given figures into the equation,

The Cost of Common Equity = Rf + B[Rm-Rf]

= 4.10% + [1.1 x 5.40%]

= 4.10% + 5.40%

= 9.50%

Bond Yield Plus Risk Premium

Bond Yield Plus Risk Premium + Bond Yield + Risk Premium

= 8.65% + 3.40%

= 12.05%

DCF Cost of Equity

As per Discounted cash flow model, The cost of common Equity = [D1 / P0] + g

Where, Dividend in next year (D) = $2.10 per share

Dividend growth rate (g) = 4.60%

Current Share Price (P0) = $21.00 per share

Therefore, The cost of common Equity = [D1 / P0] + g

= [$2.10 / $21] + 0.0460

= 0.10 + 0.0460

= 0.1460

= 14.60%

Best estimate of the firm's cost of equity

Best estimate of the firm's cost of equity would be the average of the cost of common equity calculated using the above three approaches

Best estimate of the firm's cost of equity = [9.50% + 12.50% + 14.60%] x 1/3

= 36.15% x 1/3

= 12.05%