Purchase Solution

Cost of Common Equity

Not what you're looking for?

Ask Custom Question

Why are several formulas often used to estimate the cost of common equity instead of the "right" formula?

Purchase this Solution
Solution Summary

The solution defines the cost of common equity. It then identifies and explains why several formulas are often used to estimate the cost of common equity instead of the "right" formula. Illustrative examples are also provided.

Solution Preview

Please see response below, some of which is also attached. I hope this helps and take care.
RESPONSE:

1. Why are several formulas often used to estimate the cost of common equity instead of the "right" formula?

The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity. That return is composed of the dividends paid on the shares and any increase (or decrease) in the market value of the shares. For example, if an investor expects a 10% return from McDonald's stock and she buys a share at $67.25, her expectation is to receive $6.72 during the year through a combination of dividends (currently $.34 per share during 1998) and the appreciation of the stock price (presumed to be $6.38 to give her the 10% expected return totaling $6.72) during the year (http://www.valuepro.net/approach/equity/equity.shtml).

There are three formulas to calculate the cost of common equity:

1. Use CAPM (uses beta)
2. (GORDON MODEL) The constant dividend growth model - same as DCF method
3. Bond yield - plus - risk premium (http://www.exinfm.com/training/cost_of_capital.doc).

More than one formula is used to address the different return components, mainly because the estimator of some measures will give a biased result depending on the what component you are interested in measuring. Thus, using different models increases the likelihood the estimate of the cost of equity is a reasonable one.

So, let's take a look at what rate of return, in general, an investor should expect from a stock.

For example, the return expected of any risky common stock should be composed of at least three different return components: (1) a return commensurate with a risk-free security (Rf); (2) a return that incorporates the market risk associated with common stocks as a whole (Rm); and (3) a return that incorporates the business and financial risks specific to the stock of the company itself, known as the company's beta.

1) The first measure of return (Rf) relates to what market ...

Purchase this Solution
Free BrainMass Quizzes
Understanding Management

This quiz will help you understand the dimensions of employee diversity as well as how to manage a culturally diverse workforce.

Basics of corporate finance

These questions will test you on your knowledge of finance.

Academic Reading and Writing: Critical Thinking

Importance of Critical Thinking

Situational Leadership

This quiz will help you better understand Situational Leadership and its theories.

Marketing Management Philosophies Quiz

A test on how well a student understands the basic assumptions of marketers on buyers that will form a basis of their marketing strategies.

View More Free Quizzes
Related BrainMass Solutions

  • Cost of equity and WACC

    Cost of new common stock = D1/(P0-F) + g = 3.18/32.40 + 6% =15.81% 10-8 Cost of common equity = D1/P0 + g D1 = 2.00 X 1.07 = 2.14 Cost of common equity = 2.14/22.50 + 7% = 16.51% WACC = Proportion of Debt X Cost of Debt x (1-T) + Proportion of

  • Calculating after tax cost of capital

    10 Common equity............ 13.0 70 After tax cost of capital= after tax cost of capital*weight of debt+ after tax cost of preferred stock*weight of preferred stock+ after tax cost of common equity*weight of common equity

  • Estimating common equity from retained earnings

    453559 Estimating common equity from retained earnings Your firm has been hired to help ABC Company to estimate the cost of common equity.

  • Cost of capital

    Use the DCF method to find the cost of common equity. b. Now calculate the cost of common equity from retained earnings using the CAPM method. c. What is the cost of new common stock, based on CAPM?

  • Cost of common equity

    What is Percy's cost of common equity?

  • WACC, Beta, cost of common stock, cost of equity

    How do you lower cost of equity Lower cost of equity is same as lowering of cost of common stock. Please see Part 4. 5. What is the effect of lowering the cost of equity Lowering of cost of equity will lead to reduction in WACC.

  • Cost of common equity explained in this solution

    Wacc= Weightage of Debt *Cost of debt+Weightage of Equity*Cost of equity =40%*7.2%+60%*16.51% =12.78%= Answer Response provides the steps to compute the cost of common equity

  • Cost of common equity and WACC

    142377 Cost of common equity and WACC.. Midwest Electric Company (MEC) uses only debt and equity.

  • Debt ratio/common cost equity

    Dividend anticipated to grow constant rate of 3.9% yr. Common cost equity? Debt ratio/Common cost equity Equity Multiplier of 3.71. Assets are financed with combined common equity and long term debt. Debt ratio?

  • EPS - Excel

    Calculate the firm's cost of retained earnings, and the cost of new common equity. Cost of retained earnings Cost of equity= Ks= (DIV1/Po)+g 13.58% Div1= Expected dividend per share next year.

View More Related Solutions