A B C Thumbs up to answer! The cost of equity using the bond yield plus risk pre

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A B C
Thumbs up to answer! The cost of equity using the bond yield plus risk premium approach The Adams Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Adams's bonds yield 10.28%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Adams's cost of internal equity is: 15.36% 20.21% 17.79% 16.17% The cost of equity using the discounted cashflow (or dividend growth) approach Ford Enterprises's stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firm's growth rate to be constant at 7.27%. Using the cost of equity using the discounted cashflow (or dividend growth) approach, what is Ford's cost of internal equity? 10.30% 10.82% 13.91% 12.88% o O Estimating growth rates It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate: . Carry forward a historical realized growth rate, and apply it to the future. . Locate and apply an expected future growth rate prepared and published by security analysts . Use the retention growth model. Suppose Ford is currently distributing 70.00 of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 8.00. Ford's estimated growth rate is

Explanation / Answer

A. d. 16.17%

based on yield plus risk premium approach Adam's cost of internal equity = bond yield + risk premium

=>10.28% +5.89%

=>16.17%.

B. a.10.30%

as per dividend discount model:

P = D 1 / (k - g)

here,

P = $45.56

D1 = $1.38.....(D 1 means dividend to be paid next year).

k is the rate of internal equity...(to be found out)

g = 7.27% =>0.0727.

now<

$45.56 = $1.38 / (k - 0.0727)

=>k - 0.0727 = $1.38 /45.56

=>k = 0.03028972+0.0727

=>k=0.1030...

=>k = 10.30%........(rounded to two decimals).

C.Ford's estimated growth rate = 2.4%

growth rate = retention rate * return on equity

here,

retention rate = (1 - dividend pay out rate)

=> (1 - 0.70).....(since it has been given that ford is currently distributing 70.00 of its earnings in form of cash dividends).

=>0.30.

return on equity = 8.00

growth rate= 0.30 * 8.00

=>2.4%.

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