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    Medical Associates: Calculate cost of equity using DCF, CAPM

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    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.

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    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 ...

    $2.19

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