The future earnings, dividends and common stock price of Carpetto Tech are expec

Question

The future earnings, dividends and common stock price of Carpetto Tech are expected to grow 6% per year. Carpetto’s common stock currently sells for 25$ per share; its last dividend was $2.50; and it will pay a $ 2.75 dividend at the end of the current year.

Using the DCF approach, what is its cost of common equity?

If the firms beta is 1.8, the risk free rate is 6% and the average return on the market is 10%, what is the firms cost of equity using the CAPM approach?

If the firms bonds earn a return of 10%, based on the bond yield plus risk premium approach, what will be the required return on equity? Use the midpoint of the range for the calculations.

If you have equal confidence in the inputs for the three approaches, what is your estimate of Carpetto’s cost of common equity?

Explanation / Answer

(a) Using the DCF approach, what is the cost of common equity?  

Cost of common equity Ke = D1/P0 +g

D1 = 2.50 *(1 + 0.06) = 2.65

Ke = 2.65/25 + 0.06

      = 16.60%

(b) If the firms beta is 1.8, the risk free rate is 6% and the average return on the market is 10%, what is the firms cost of equity using the CAPM approach?

Required rate of return = Risk free rate + beta x Market risk premium

                                    = 6% + 1.8 *(10% - 6%)

                                    = 13.20%

If the firms bonds earn a return of 10%, based on the bond yield plus risk premium approach, what will be the required return on equity? Use the midpoint of the range for the calculations.

Rs= Bond yield + Risk premium
=10%+4%
=14%

(d) Assuming you have equal confidence in the inputs used for the three approaches, what is your estimate of Carpetto's cost of common equity?

It is difficult to estimate beta and also growth rate has to be assumed to be constant. Thus bond-yield plus risk premium approach is appropriate to calculate cost of equity.

Cost of common equity Ke = D1/P0 +g

=(2.65)/25+6%
=16.60%

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