Question

eBook Problem Walk-Through The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 4% per year. Callahan's common stock currently sells for $25.75 per share; its last dividend was $2.50; and it will pay a $2.60 dividend at the end of the current year. Using the DCF approach, what is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.   % If the firm's beta is 2.0, 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.   % 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.   % 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

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Answer:

Dividend growth rate (g) = 4% per year

Common Stock value (P₀) = $25.75 per share

Dividend just paid (or) Last dividend (D₀) = $2.50

Current year dividend to pay (D₁) = $2.60

(a)    Using the DCF approach, what is its cost of common equity?

Cost of Common Equity (R) = [D₁ / P₀] +g

Cost of Common Equity (R) = [$2.6 / $25.75] + 0.04

Cost of Common Equity (R) = 14.10%

(b)    If the firm’s beta is 2.0, 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?

Beta = 2.0

Risk-free rate (R_f) = 7%

Return on the Market (R_M) = 13%

Calculating Firm’s Cost of Common Equity using the CAPM approach:

According to CAPM approach:

Cost of common equity (R_E) = [R_f + β (R_M – R_f)]

Cost of common equity (R_E) = [7% + 2 (13% - 7%)]

Cost of common equity (R_E) = 19.0%

(c)    If the firm’s bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be r_s?

r_s= Bond rate + Risk premium

r_s= 11% + 6%

r_s= 17%

d. The two approaches bond-yield-plus-risk premium approach and CAPM both has lower cost of equity than the DCF method. The firm’s cost of equity estimated to be 16.70% which is the average of all the three methods.