The future earnings, dividends, and common stock price of Carpetto Tec

QUESTION

The future earnings, dividends, and common stock price of Carpetto Technologies Inc. are expected to grow 7% per year. Carpettos common stock currently sells for $23.00 per share; its last dividend was $2.00; and it will pay a $2.14 dividend at the end of the current year.a) Using the DCF approach,
Dividend growth rate (g) = 7% per year Common Stock value (P 0 ) = $23 per share Dividend just paid (or) Last dividend (D 0 ) = $2 Current year dividend to pay (D 1 ) = $2.14 (a) Using the DCF approach, what is its cost of common equity? Cost of Common Equity (R) = [D 1 / P 0 ] g Cost of Common Equity (R) = [$2.14 / $23] 0.07 Cost of Common Equity (R) = 0.1630 (or) 16.30% Cost of Common Equity (R) = 16.30% (b) If the firms beta is 1.6, the risk-free rate is 9%, and the average return on the market is 13%, what will be the firms cost of common equity using the CAPM approach? Beta = 1.6 Risk-free rate (R f ) = 9% Return on the Market (R M ) = 13% Calculating Firms Cost of Common Equity using the CAPM approach: According to CAPM approach: Cost of common equity (R E ) = [R f (R M R f )] Cost of common equity (R E ) = [9% 1.6 (13% –

%)] Cost of common equity (R E ) = [9% 1.6 (4%)] Cost of common equity (R E ) = [0.09 1.6 (0.04)] Cost of common equity (R E ) = 0.154 (or) 15.4% Cost of common equity (R E ) = 15.4% (c) If the firms bonds earn a return of 12%, based on the bond-yield-plus-risk-premium approach, what will be r s ? r s = Bond rate Risk premium r s = 12% 4% r s = 16% d. The two approaches bond-yield-plus-risk premium approach and CAPM both has lower cost of equity than the DCF method. The firms cost of equity estimated to be 15.9% which is the average of all the three methods.

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