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 = 6%. The firm's current common stock price, P0, is $24.00. The current risk-free rate, rRF, = 4.4%; the market risk premium, RPM, = 5.7%, and the firm's stock has a current beta, b, = 1. Assume that the firm's cost of debt, rd, is 8.73%. The firm uses a 3.7% 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.

Explanation / Answer

1) CAPM Approach:

R = rf + Beta * mp (i.e. rm - rf)

Cost of Equity = R = 0.044 + 1 * 0.057 = 0.101 = 10.10%

2) Discounted Cash Flow (DCF) Approach:

P0 = D0 ( 1 + g) / R - g = D1 / R - g

=> 24 = 2.10 / R - 0.06 and now solving it for R, we get = Cost of Equity = 0.1475 = 14.75%

3) Bond Yield plus Risk premium Approach :

R =Cost of Equity = Bond Yield or Cost of Debt + Risk Premium = 0.0873 + 0.037 = 0.1243 = 12.43%

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