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 $1.70 and it expects dividends to grow at a constant rate g = 4.4%. The firm's current common stock price, P0, is $20.00. The current risk-free rate, rRF, = 4.5%; the market risk premium, RPM, = 5.8%, and the firm's stock has a current beta, b, = 1.2. Assume that the firm's cost of debt, rd, is 8.38%. The firm uses a 3.8% 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: % What is your best estimate of the firm's cost of equity?

Explanation / Answer

Capital-asset-pricing-model (CAPM) approach:-

Cost of retained earnings (ks)= rf + bi (rm - rf)

                                             =4.5%+1.2(5.8%-4.5%)

                                                       =6.06%

Bond-yield-plus-premium approach

Cost of debt+ risk premium    =8.38%+3.8%

=12.18%

Discounted cash flow approach:-

Cost of equity= (D1/P0) +g

=($1.70/$20.00) +4.4%=12.90%

The CAPM method is the most popular method used by companies in estimating the cost of equity.

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