Question

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 8% per year. Callahan's common stock currently sells for $25.25 per share; its last dividend was $1.50; and it will pay a $1.62 dividend at the end of the current year.
1. Using the DCF approach, what is its cost of common equity?
2. If the firm's beta is 0.80, the risk-free rate is 3%, and the average return on the market is 14%, what will be the firm's cost of common equity using the CAPM approach?
3. If the firm's bonds earn a return of 12%, based on the bond-yield-plus-risk-premium approach, what will be rs?
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?

Answer 1

Answer:

Find my detailed explanations and answers below

Explanation:

1.

Based on the dividend discount model, the share price is the present value of the expected dividend as shown by the formula below:

share price=expected dividend/(cost of equity-growth rate)

share price=$25.25

expected dividend=$1.62

cost of equity=unknown(let us assume it is K)

growth rate=8%

$25.25=$1.62/K-8%

$25.25*(K-8%)=$1.62

K-8%=($1.62/$25.25)

K=($1.62/$25.25)+8%

K=14.42%

2.

Using the Capital Asset Pricing Model, the formula for cost of equity is as shown thus:

cost of equity=risk-free rate+beta*(market return-risk-free rate)

risk-free rate=3%

beta=0.80

,market return=14%

cost of equity=3%+0.80*(14%-3%)

cost of equity=11.80%

3.

cost of equity=cost of debt+risk premium

cost of debt=12%

risk premium=market return-risk-free rate=14%-3%=11%

cost of equity=12%+11%=23%

If all of the figures are of equal confidence, our cost of equity should be the average of the three

cost of equity=(14.42%+11.80%+23%)/3=16.41%