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Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 30%, and the current dividend yield is 2%. Its beta is 1.2, the market risk premium is 8%, and the risk-free rate is 4%. (LO13-4) a. Use the CAPM to estimate the firm’s cost of equity. b. Now use the constant growth model to estimate the cost of equity. c. Which of the two estimates is more reasonable?

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Answer:

a. 13.60 %

b. 10.00 %

c. CAPM accounts for investment risk and can be applied by any company irregardless of dividend size or growth rate.

Explanation:

Cost of Equity is the return required by holders of Common Stock

1. CAPM

Cost of Equity = Expected Return on Risk Free Security + Company`s Beta × Market Risk Premium

                       = 0.04 + 1.20 × 0.08

                       = 13.60 %

2. Constant growth model

Cost of Equity = Current Dividend Yield + Expected Growth

                        = 2 % + 8 %

                        = 10.00 %

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