4. Problem 10.06 (Cost of Common Equity)

eBook Problem Walk-Through

The future earnings, dividends, and common stock price of Callahan Technologies Inc. are expected to grow 8% per year. Callahan's common stock currently sells for $26.25 per share; its last dividend was $2.50; and it will pay a $2.70 dividend at the end of the current year.

Using the DCF approach, what is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

%

If the firm's beta is 1.7, the risk-free rate is 3%, and the average return on the market is 12%, what will be the firm's cost of common equity using the CAPM approach? Round your answer to two decimal places.

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If the firm's bonds earn a return of 11%, based on the bond-yield-plus-risk-premium approach, what will be r_s? Use the judgmental risk premium of 4% in your calculations. Round your answer to two decimal places.

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If you have equal confidence in the inputs used for the three approaches, what is your estimate of Callahan's cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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Part B.

Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of r_d = 11% as long as it finances at its target capital structure, which calls for 40% debt and 60% common equity. Its last dividend (D₀) was $3.00, its expected constant growth rate is 3%, and its common stock sells for $23. EEC's tax rate is 25%. Two projects are available: Project A has a rate of return of 15%, and Project B's return is 10%. These two projects are equally risky and about as risky as the firm's existing assets.

What is its cost of common equity? Do not round intermediate calculations. Round your answer to two decimal places.

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What is the WACC? Do not round intermediate calculations. Round your answer to two decimal places.

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Which projects should Empire accept?