1. The current risk-free rate of return is 4.20% and the current market risk pre

Question

1. The current risk-free rate of return is 4.20% and the current market risk premium is 6.60%. Fuzzy Button Clothing Company has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, what is Fuzzy Button’s cost of equity?

2. Green Caterpillar Garden Supplies Inc. is closely held and, as a result, cannot generate reliable inputs for the CAPM approach. Green Caterpillar’s bonds yield 10.20%, and the firm’s analysts estimate that the firm’s risk premium on its stock relative to its bonds is 4.50%. Using the Bond-Yield-plus-Risk-Premium approach, what is the firm’s cost of equity?

3. The stock of Blue Hamster Manufacturing Inc. is currently selling for $45.56, and the firm expects its dividend to be $2.35 in one year. Analysts project the firm’s growth rate to be constant at 7.20%. Using the discounted cash flow (DCF) approach, Blue Hamster’s cost of equity is estimated to be what?

Explanation / Answer

Q1) CAPM Model -

Cost of quity = Risk Free Rate + Beta of the security( Risk Free rate + Expected Market Return), please note -

(Risk Free rate + Expected Market Return) = Market Risk Premium.

Inserting relevant figures in the equation gives us -

X = .042 + 1.56( .066)

X = .1449 = 14.49 %

Q2) Cost of Equity with Bond Yield plus Risk premium approach = Company's cost of debt + Equity risk premium in excess of the company's cost of debt.

Inserting relevant figures from ques we get --------

.1020 + .0450 = .147 = 14.7 %

Q3) Ques can be answered using DDM model and not DCF, since DCF model requires an account of cash flows expected in the future and not just one dividend due next year.

Dividend Discount model -

P0 = Dividend1 / (R-G), where R = Cost of equity ; G = Firms Growth rate assumed, P0 = Current share price; Dividend1 = Dividend next year

Inserting figures from ques we get -

45.56 = 2.35 / (R - .072), Solving for R we get ; R = .1235 = 12.35 %

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