# Cost of Common Equity The future earnings, dividends, and a common stock price of Carpetto...

## Question:

Cost of Common Equity

The future earnings, dividends, and a common stock price of Carpetto Technologies Inc. are expected to grow 5% per year. Carpetto's common stock currently sells for $21.00 per share; its last dividend was$2.20, and it will pay a \$2.31 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. %

If the firm's beta is 1.30, the risk-free rate is 8%, and the average return on the market is 14%, 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 10%, 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 Carpetto's cost of common equity? Round your answer to two decimal places. %

## Cost of equity:

Cost of equity is the cost of financing through the common stockholders of the company. Financing through common stockholders result in giving up a stake of the company. It can be calculated as per several methods, such as the Dividend growth model, CAPM or capital asset pricing model, etc.

## Answer and Explanation:

Cost of equity as per DCF approach is
= Next dividend / Current price x 100
= 2.31 / 21 + 0.05
= 0.16
= 16%

Cost of equity as per CAPM
= Risk free rate + (Market return - Risk free rate) x Beta
= 8% + (14% - 8%) x 1.30
= 15.80%

Cost of equity as per bond-yield-plus-risk-premium-approach
= Bond yield + Risk premium
= 10% + 7.80% = 17.80%

• Since no range of risk premium is given, the risk premium from the CAPM model return is taken.
• Risk premium = Stock return - Riskfree rate = 15.80% - 8% = 7.80%

Now, If we have equal confidence, then Cost of equity = 16% x 1/3 + 15.80% x 1/3 + 17.80% x 1/3 = 16.53%