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Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250

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BuyFindarrow_forward

Fundamentals of Financial Manageme...

15th Edition
Eugene F. Brigham + 1 other
ISBN: 9781337395250
Textbook Problem

COST OF COMMON EQUITY The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 6% per year. Callahan’s common stock currently sells for $22.00 per share; its last dividend was $2.00; and it will pay a $2.12 dividend at the end of the current year.

  1. a. Using the DCF approach, what is its cost of common equity?
  2. b. If the firm's beta is 1-2, the risk-free rate is 6%, and the average return on the market is 13%, what will be the firm's cost of common equity using the CAPM approach?
  3. c. 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.
  4. d. If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan’s cost of common equity?

a.

Summary Introduction

To determine: The cost of common equity as per the DCF approach.

Introduction:

Cost of Equity

It is the cost of capital which results while raising finance by issuing equity. It is the earnings from the investment to the firm’s equity investors. It is the return to the stockholders’’ equity investments.

DCF Approach

In this approach the value of stock of the company is the present value of all cash flows discounted at the required return of the investors.

Explanation

Explanation:

Given information:

Expected dividend is $2.12.

Current price of the stock is $22 per share.

Growth rate is 6% or 0.06.

The formula to calculate cot of common equity as per DCF approach is:

r=D1P0+g

Where

  • D1 is the next expected dividend.
  • P0 is the current price of the stock.
  • g is the constant growth rate

b.

Summary Introduction

To determine: The cost of common equity as per the CAPM approach.

Introduction:

Capital Assets Pricing Model (CAPM)

As per this approach, the cost of equity is the required return to the investors which is the minimum return expected by the investors to take an additional risk. This can be calculated by adding the risk premium to the risk-free rate. Risk premium is the cost of taking additional risk.

c.

Summary Introduction

To calculate: Cost of equity as per bond-yield-plus-risk-premium approach.

Introduction:

Bond-Yield-Plus-Risk-Premium:

As per this approach the equity cost is the total of the bond yield and risk premium. This method is based on the assumption that the equity is more risky, so it must be rewarded with additional return that is risk premium.

d.

Summary Introduction

To identity: The estimated cost of common equity of C Company.

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