Problem 10-6 Cost of Common Equity The future earnings, dividends, and common st
ID: 2805722 • Letter: P
Question
Problem 10-6
Cost of Common Equity
The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 4% per year. Callahan's common stock currently sells for $20.25 per share; its last dividend was $2.00; and it will pay a $2.08 dividend at the end of the current year.
Using the DCF approach, what is its cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
%
If the firm's beta is 1.80, the risk-free rate is 4%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.
%
If the firm's bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be rs? Use the midpoint of the risk premium range discussed in Section 10-5 in your calculations. Round your answer to two decimal places.
%
If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Round your answer to two decimal places. Do not round your intermediate calculations.
%
Explanation / Answer
Answer a
Year-end Dividend, D1 = $2.08
growth rate, g = 4%
Current Price, P0 = $20.25
Cost of Common Equity = D1 / P0 + g
Cost of Common Equity = $2.08 / $20.25 + 0.04
Cost of Common Equity = 0.1427
Cost of Common Equity = 14.27%
Answer b.
Risk-free Rate = 4%
Beta = 1.80
Return on Market = 13%
Cost of Common Equity = Risk-free Rate + beta * (Return on Market - Risk-free rate)
Cost of Common Equity = 0.04 + 1.80 * (0.13 - 0.04)
Cost of Common Equity = 0.202 = 20.20%
Answer c.
According to section 10-5, risk premium is between the range 3% to 5%.
Average Risk premium = 4%
Cost of Common Equity = Bond Yield + Average risk premium
Cost of Common Equity = 11% + 4%
Cost of Common Equity = 15.00%
Answer d.
Estimated Cost of Common Equity = (14.27% + 20.20% + 15.00%) / 3
Estimated Cost of Common Equity = 16.49%
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