The future earnings, dividends, and common stock price of Carpet to Technologies

Question

The future earnings, dividends, and common stock price of Carpet to Technologies Inc. are expected to grow 8% per year. Carleton's common stock currently sells for $21.00 per share; its last dividend was $1.50; and it will pay a $1.62 dividend at the end of the current year. Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. If the firm's beta is 1.60, the risk-free rate is 5%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places. If the firm's bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Carleton's cost of common equity? Round your answer to two decimal places.

Explanation / Answer

a.

As per DCF approach,

Cost of equity = (Dividend at year 1/Price of share at year 0) + Growth rate

Cost of common equity = ($1.62/$21) + 0.08 = 0.1571 = 15.71%

b.

As per CAPM approach,

Cost of equity = Risk free return + Beta*(Market return – Risk free return)

Cost of common equity = 0.05 + 1.60*(0.12-0.05) = 0.05 + 0.112 = 0.162 = 16.20%

c.

Cost of equity = Bond yield + Risk premium = 11% + 5% = 16%

d.

Estimated cost of common equity = (15.71% * 1/3) + (16.20% * 1/3) + (16% * 1/3) = 15.97%

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