Barry\'s common stock is currently selling for $50 a share. Its last dividend wa

Question

Barry's common stock is currently selling for $50 a share. Its last dividend was $4.19, and dividends are expected to grow at a constant rate of 5% in the forseeable future. Barry's beta is 1.2, and its yield on a T-bond is 5%, and the market risk premium is estimated at 5%. For the bond yield plus risk premium approach, use a maximum risk premium.

A. What is Barry's estimated cost of common equity based on the CAPM approach?  

B. What is Barry's estimated cost of common equity using the DCF approach?

C. What is the bond yield plus risk premium estimate to Barry's cost of common equity?

Explanation / Answer

A. Barry's estimated cost of common equity based on the CAPM approach:

ra = rf + Ba (rm-rf)

so, Cost of common equity = 5% + 1.2 (5% - 5%) = 5%

B. Barry's estimated cost of common equity using the DCF (expected dividend cash flow) approach:

Cost of common equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate

   = [ $4.19 (1.05) / 50] + 5%

= 8.8% + 5% = 13.8%

C. The bond yield plus risk premium estimate to Barry's cost of common equity:

= yield on a T-bond 5% + market risk premium 5% = 10%

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