Barton Industries estimates its cost of common equity by using three approaches:

Question

Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate g = 3.4%. The firm's current common stock price, P0, is $20.00. The current risk-free rate, rRF, = 4.7%; the market risk premium, RPM, = 6%, and the firm's stock has a current beta, b, = 1.3. Assume that the firm's cost of debt, rd, is 9.2%. The firm uses a 4% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places.

CAPM cost of equity:

Bond yield plus risk premium:

DCF cost of equity:

Explanation / Answer

a,CAPM cost of equity is given by Re = Rf + beta*(Rm - Rf) where Rf = 4.7%, beta = 1.3 and (Rm-Rf) = 6%

Hence Re = 4.7 + 1.3*6 = 12.5%

So, cost of equity (CAPM) =12.5%

b. Bond yield + Risk premium approach: Bond yield = 9.2%. Risk premium = 4%

So total cost of equity = 9.2 + 4 = 13.2%

c. The DCF cost of equity is given by: Ke = D1/P0 + g

where D1 = dividend next year = 2.10

P0 = Current stock price = 20

g = growth rate = 3.4% = 0.034

Hence Cost of equity = 2.10/20 + 0.034 = 0.139 = 13.9%

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