Labree Laboratories estimates its cost of common equity by calculating it using three different methods and taking the average of the methods. Labree's stock is currently selling for $50, and its expected dividend for next year is $2.50. The dividend is expected to grow at a constant rate of 7 percent. The firm also has bonds outstanding that yield 8 percent. Analysts estimate that Labree's common equity has a risk premium of 3 percent over its bond yield. Labree's beta is 1.1. If the risk-free rate is 4 percent and the market risk premium is 6 percent, what is the best estimate of Labree's cost of common equity?
A) 10.5%
B) 11.0%
C) 11.2%
D) 11.7%
E) 12.0%

Question

Quizplus · Accepted Answer

The correct answer is C.The cost of common equity can be calculated using the following three methods:1. Dividend Growth Model: The dividend growth model calculates the cost of common equity as the dividend yield plus the expected growth rate of dividends. In this case, the dividend yield is $2.50/$50 = 5%, and the expected growth rate of dividends is 7%. Therefore, the cost of common equity using the dividend growth model is 5% + 7% = 12%.2. Capital Asset Pricing Model (CAPM): The CAPM calculates the cost of common equity as the risk-free rate plus the beta of the stock multiplied by the market risk premium. In this case, the risk-free rate is 4%, the beta of the stock is 1.1, and the market risk premium is 6%. Therefore, the cost of common equity using the CAPM is 4% + 1.1 * 6% = 10.6%.3. Bond Yield Plus Risk Premium: This method calculates the cost of common equity as the yield on the firm's bonds plus a risk premium. In this case, the yield on the firm's bonds is 8%, and the risk premium is 3%. Therefore, the cost of common equity using this method is 8% + 3% = 11%.The average of the three methods is (12% + 10.6% + 11%) / 3 = 11.2%. Therefore, the best estimate of Labree's cost of common equity is 11.2%.

Labree Laboratories Estimates Its Cost of Common Equity by Calculating