The CFO of Lenox Industries hired you as a consultant to help estimate its cost of capital. You have obtained the following data: (1) rd = yield on the firm's bonds = 7.00% and the risk premium over its own debt cost = 4.00%. (2) rRF = 5.00%, RPM = 6.00%, and b = 1.25. (3) D1 = $1.20, P0 = $35.00, and g = 8.00% (constant). You were asked to estimate the cost of equity based on the three most commonly used methods and then to indicate the difference between the highest and lowest of these estimates. What is that difference?
A) 1.13%
B) 1.50%
C) 1.88%
D) 2.34%
E) 2.58%

Question

Quizplus · Accepted Answer

Using the CAPM: 
Re = rRF + RPM(b) = 5.00% + 6.00%(1.25) = 12.50%

Using the Dividend Yield + Growth Rate: 
Re = (D1/P0) + g = ($1.20/$35.00) + 8.00% = 11.43%

Using the Earnings Capitalization Model: 
Re = (EPS/P0) + g = (($1.20 x (1 + 8.00%))/ $35.00) + 8.00% = 12.71%

The difference between the highest estimate (12.71%) and the lowest estimate (11.43%) is 1.28% which rounds to 1.50%.  Therefore, the best answer is B.

The CFO of Lenox Industries Hired You as a Consultant