You have been hired by the CFO of Lugones Industries to help estimate its cost o
ID: 2776646 • Letter: Y
Question
You have been hired by the CFO of Lugones Industries to help estimate its cost of common equity. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of common based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference? a. 1.50% b. 2.58% c. 2.34% d. 1.88% e. 1.13%
Explanation / Answer
Cost of equity by:
Method 1 : Bond yield plus risk premium method
= yield on the firm's bonds (7.00%) + risk premium over its own debt cost (4.00%) = 11%
Method 2 : CAPM
Cost of equity = Risk free rate + beta + market risk premium
= 5 + 1.25* 6 = 12.5%
Method 3 : Constant dividend growth model
Price = Next year dividend / ( cost of equity - costant growth rate)
35 = 1.2 /( r - .08)
r = 11.428%
Highest = 12.5%
Lowest = 11%
difference = 12.5 - 11 = 1.5%
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