Barton Industries estimates its cost of common equity by using three approaches:

Question

Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, D1, to be $2.10 and it expects dividends to grow at a constant rate g = 4%. The firm's current common stock price, P0, is $29.00. The current risk-free rate, rRF, = 4.3%; the market risk premium, RPM, = 5.6%, and the firm's stock has a current beta, b, = 1.1. Assume that the firm's cost of debt, rd, is 7.25%. The firm uses a 3.6% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to 2 decimal places.

Explanation / Answer

CAPM cost of equity:

According to CAPM,

Cost of equity = risk free rate + beta*market risk premium

CAPM cost of equity = 4.3% + 1.1*5.6% = 10.46%

Bond yield plus risk premium = cost of debt + risk premium = 7.25% + 3.6% = 10.85%

DCF cost of equity:

According to dividend-discount model,

P0 = D1/(R-G)

P0 = Current stock price

D1 - Dividend at t =1

R - Cost of equity

G - Growth rate

29 = 2.1/(R-4%)

R = 11.24%

DCF cost of equity = 11.24%

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