The earnings, dividends, and common stock price of Shelby Inc. are expected to g

Question

The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 8% per year in the future. Shelby's common stock sells for $26.00 per share, its last dividend was $1.50, and the company will pay a dividend of $1.62 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 1.7, the risk-free rate is 5%, and the expected return on the market is 14%, 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

1.   Using the discounted cash flow approach:-

required rate of return(cost of equity) = next year dividend / current stock price + growth rate

= $1.62 / $26 + 8%

= 6.23% + 8%

=14.23%

2.  cost of equity based on the CAPM approach:-

cost of equity = risk free rate + beta (market return - risk free return)

=5% + 1.7 (14% - 5%)

= 5% + 1.7 *9%

= 5% + 15.3%

= 20.3%

3.   bond-yield-plus-judgmental-risk-premium approach:-

This approach provides the cost of equity by adding the market risk premium of equity with the cost of debt(return percentage of bond)

cost of equity = bond rate + risk premium

= 11% + 9%

=20%

Note:- risk premium = market return - risk free return

=14% - 5%

= 9%

4    estimate of Shelby's cost of equity :-

After calculating cost of equity from the different methods from part 1 to part 4, Final firm cost of equity will be calculated by average of the all the cost of equities calculated under the above three method

Cost of equity = (14.23% + 20.3% + 20%) / 3

= 54.53% / 3

=18.18%

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