Question

The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.50. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?

Answer 1

Answer:

Ans.

Method 1. 11% (Bond yield and risk premium)

Method 2. 14% (CAPM)

Method 3. 11.43% (DIvidend method)

Difference between the highest and lowest = 3%

Step-by-step explanation:

Hi, let´s find the the cost of equity with all 3 methods.

Method 1.

$r(e)=YieldBond+RiskPremium=0.07+0.04=0.11$

First method = 11%

Method 2.

$r(e)=rf+Beta(RPM)=0.05+1.5*0.06=0.14$

Second method =14%

Method 3.

$r(e)=\frac{D1}{Po} +g=\frac{1.20}{35} +0.08=0.1143$

Third method = 11.43%

Now, the difference between the highest and lowest is:

$Difference=0.14-0.11=0.03$

Difference = 3%

Best of luck.