Question

Cost of Common Equity

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 $21.00 per share; its last dividend was $1.50; and it will pay a $1.56 dividend at the end of the current year.

1. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
   %
2. If the firm's beta is 2.20, the risk-free rate is 4%, and the average return on the market is 14%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
   %
3. If the firm's bonds earn a return of 10%, based on the bond-yield-plus-risk-premium approach, what will be r_s? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.
   %
4. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
   %

Answer 1

Requirement (a) – Cost of Common Equity using DCF Approach

Dividend in year 1 (D1) = $1.56 per share

Current selling price per share (P0) = $21.00 per share

Dividend growth Rate (g) = 4.00% per year

Therefore, the Cost of Common Equity = [D1 / P0] + g

= [$1.56 + $21.00] + 0.05

= 0.0743 + 0.05

= 0.1143 or

= 11.43%

“The Cost of Common Equity = 11.43%”

Requirement (b) – Cost of Common Equity using CAPM Approach

Cost of Common Equity using CAPM Approach = Rf + Beta[Rm – Rf]

= 4.00% + 2.2[14.00% - 4.00%]

= 4.00% + [2.2 x 10.00%]

= 4% + 22.00%

= 26.00%

“Cost of Common Equity = 26.00%”

Requirement (c) – Cost of Common Equity Bond Yield Risk Premium Approach

The appropriate risk premium discussed in section 10-5 is from 3% to 5%. Therefore, the mid-point of the range is 4%

Therefore, The Cost of Common Equity Bond Yield Risk Premium Approach = Return of the Bond + Mid point of the range

= 10.00% + 4.00%

= 14.00%

“Therefore, The “Rs = 14.00%”

Requirement (d) – Cost of common equity using equal confidence

Using Equal Confidence, the cost of common equity would be the average of the cost of common equity calculated under the above 3 alternatives,

Cost of Common Equity = [11.43% + 26.00% + 14.00%] / 3

= 51.43% / 3

= 17.14%

“Callahan's cost of common equity = 17.14%”