Problem 10-6. Cost of common equity The earnings, dividends, and common stock pr

Question

Problem 10-6. Cost of common equity

The earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow at 5% per year in the future. Carpetto's common stock sells for $20.50 per share, its last dividend was $1.80, and it will pay a dividend of $1.89 at the end of the current year.

a. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places.
%

b. If the firm's beta is 2.00, the risk-free rate is 8%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
%

c. If the firm's bonds earn a return of 9%, what will rs be based on the bond-yield-plus-risk-premium approach, using the midpoint of the risk premium range as suggested in studies? Round your answer to two decimal places.
%

d. Assuming you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity? Round your answer to two decimal places.
%

Explanation / Answer

1.89/(r-.05)= 20.50
Solving for r we get .142195 or 14.22%

8 + 2(12-8)= 16%

Bond yield plus risk premium
9 +(12-8)= 13%

Bond plus risk premium probably the best approach 13%.

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