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Medical Associates: Calculate cost of equity using DCF, CAPM

Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firm's last dividend (D0) was $2, and its current stock price is $23. The firm's beta coefficient is 1.6; the rate of return on 20-year T-bonds currently is 9%; the expected rate of return is 13%. The firm's target capital structure calls for 50% debt financing, the interest rate required on the business's new debt is 10%, and its tax rate is 40%.

1. Calculate Medical Associates' cost of equity estimate using the DCF method.

2. Calculate the cost of equity estimate using CAPM.

3. On the basis of your answers to #1 & #2, what is your final estimate for the firm's cost of equity?

4. Calculate the firm's estimate for corporate cost of capital.

5. Describe how is project risk is incorporated into a capital budgeting analysis.

Solution Preview

1. Using the DCF method
Cost of Equity = D1/P0 + g
D1 = expected dividend= D0 X (1+g) = 2 X 1.07 = 2.14
P0 current price = $23
g = growth rate = 7%
Cost of equity = 2.14/23 + 7% = 16.30%

2. Using CAPM
Cost of equity = Rf + (Rm-Rf) beta
Rf = risk free rate = 9%
Rm = return on ...