The earnings, dividends, and stock price of Shelby Inc.

are expected to grow at 7% per

year in the future. Shelbys common stock sells for $23 per share, its last dividend was
$2.00, and the company will pay a dividend of $2.14 at the end of the current year.
a. Using discounted cash flow approach, what is the cost of equity?
ks =

D1
$2.14
+g=
+ 7% = 9.3% + 7% = 16.3%.
$23
P0

b. If the firms beta is 1.6, the risk free rate is 9% and the expected return on the market is
13%, what will be the firms cost of equity using the CAPM approach?
ks = kRF + (kM - kRF)b
= 9% + (13% - 9%)1.6 = 9% + (4%)1.6 = 9% + 6.4% = 15.4%.
c. If the firms bonds earn a rate of return of 12%, what will rs be using the bond-yieldplus-risk-premium approach? Use the midpoint of the risk premium range.
ks = Bond rate + Risk premium = 12% + 4% = 16%.
d. On the basis of the results of parts a through c, what would you estimate Shelbys cost
of equity to be?
The firm's cost of equity should be estimated to be about 15.9 percent, which is the
average of the three methods.