Problem 11-10 Cost of Equity The earnings, dividends, and common stock price of

Question

Problem 11-10 Cost of Equity The earnings, dividends, and common stock price of Shelby Inc. are expected to grow at 3% per year in the future. Shelby's common stock sells for $20.25 per share, its last dividend was $2.00, and the company will pay a dividend of $2.06 at the end of the current year. a. Using the discounted cash flow approach, what is its cost of equity? Round your answer to two decimal places b. If the firm's beta is 19, the risk-free rate is 6%, and the expected return on the market is 12%, then what would be the firm's cost of equity based on the CAPM approach? Round your answer to two decimal places c. If the firm's bonds earn a return of 9%, and analysts estimate the market risk premium is 3 to 5 percent, then what would be your estimate of r, using the over-own-bond-yield-plus- judgmental-risk-premium approach? Round your answer to two decimal places. (Hint: Use the midpoint of the risk premium range) d. On the basis of the results of parts a through c, what would be your estimate of Shelby's cost of equity? Assume Shelby values each approach equally. Round your answer to two decimal places.

Explanation / Answer

a. cost of equity = 2.06/20.25 + 3% = 13.17%

b. cost of equity = 6 + 1.9*6 = 17.40%

c. cost of equity = 9 + 4 = 13%

d. cost of equity = average (13.17, 17.40, 13) = 14.52%

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