Problem 9-10 Cost of Equity The earnings, dividends, and common stock price of S

Question

Problem 9-10
Cost of Equity

The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 4% per year in the future. Shelby's common stock sells for $26.25 per share, its last dividend was $1.50, and the company will pay a dividend of $1.56 at the end of the current year.

Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places.
%

If the firm's beta is 1.9, the risk-free rate is 5%, and the expected return on the market is 12%, then what would be the firm's cost of equity based on the CAPM approach? Round your answer to two decimal places.
%

If the firm's bonds earn a return of 11%, and analysts estimate the market risk premium is 3 to 5 percent, then what would be your estimate of rs using the over-own-bond-yield-plus-judgmental-risk-premium approach? Round your answer to two decimal places. (Hint: Use the midpoint of the risk premium range).
%

On the basis of the results of parts a through c, what would be your estimate of Shelby's cost of equity? Assume Shelby values each approach equally. Round your answer to two decimal places.
%

Explanation / Answer

We have:

D1= 1.56

G= 4%

P = 26.25

Ke using DDM = D1/P + g

                                =1.56/26.25 + 0.04

                                = 9.94%

Beta =1.90

Rf = 5%

Rm=12%

Ke using CAPM = Rf + (Rm-Rf) xbeta

                                =5% +(12%-5%)X1.90

                                = 18.30%

MRP = 3%

Bond return = 11%

Ke = 11%+3% =14%

We need to calculate the average of Kes under all the approaches .

Average Ke =9.94% +18.30% +14%)/3

                      =14.08%

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