Answer:
Dividend growth rate (g) = 7% per year
Common Stock value (P0) = $23 per share
Dividend just paid (or) Last dividend (D0) = $2
Current year dividend to pay (D1) = $2.14
(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) = [$2.14 / $23] + 0.07
Cost of Common Equity (R) = 0.1630 (or) 16.30%
Cost of Common Equity (R) = 16.30%
(b) If the firm’s beta is 1.6, the risk-free rate is 9%, and the average return on the market is 13%, what will be the firm’s cost of common equity using the CAPM approach?
Beta = 1.6
Risk-free rate (Rf) = 9%
Return on the Market (RM) = 13%
Calculating Firm’s Cost of Common Equity using the CAPM approach:
According to CAPM approach:
Cost of common equity (RE) = [Rf + β (RM – Rf)]
Cost of common equity (RE) = [9% + 1.6 (13% - 9%)]
Cost of common equity (RE) = [9% + 1.6 (4%)]
Cost of common equity (RE) = [0.09 + 1.6 (0.04)]
Cost of common equity (RE) = 0.154 (or) 15.4%
Cost of common equity (RE) = 15.4%
(c) If the firm’s bonds earn a return of 12%, based on the bond-yield-plus-risk-premium approach, what will be rs?
rs= Bond rate + Risk premium
rs= 12% + 4%
rs= 16%
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 15.9% which is the average of all the three methods.
Explanation:
