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Homework answers / question archive / Quantitative Problem: 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
Quantitative Problem: 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, Di, to be 51.130 and it expects dividends to grow at a constant rate g = 4.1%. The firm's current common stock price, Pc, is $29.00. The current risk-free rate, risa. = 4.6%; the market risk premium. RN, = 5.9%. and the firm's stock has a current beta, b, = 1.3. Assume that the firm's cost of debt, re, is 7.39%. The firm uses a 3.9% 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 two decimal places.
CAPM cost of equity: Bond yield plus risk premium: DCF cost of equity:
96 96
What is your best estimate of the firm's cost of equity?
The be estimate Is the highest percentage of the three approaches. The be ettrnate sa the average of the three approacheb. The be e>ttrnate sa the luereg percentage of the three approathea.
1) Computation of Cost of Common Equity using CAPM Approach:
Cost of Common Equity = rRF + B *RPm
Here,
rRF = Risk-free Rate = 4.6%
B = Beta of the stock = 1.3
RPm = Market Risk Premium = 5.9%
Cost of Common Equity = 4.60% + 1.3 * 5.90%
= 4.60% + 7.67%
= 12.27%
2) Computation of Bond Yield Plus Risk Premium:
Bond Yield Plus Risk Premium = Bond Yield + Risk Premium
= 7.39% + 3.90%
= 11.29%
3) Computation of DCF Cost of Equity:
Cost of common Equity = [D1 / P0] + g
Here,
D1 = Dividend in next year = $1.80
P0 = Current Share Price = $29
g = Growth rate = 4.1%
Cost of Common Equity = ($1.80/$29) + 4.1%
= 6.21% + 4.1%
= 10.31%
4) The best is the average of the three approaches.
