As an investor, one of the most important things to consider is the cost of equity. In simple terms, this is the return that shareholders demand for investing in a particular company. There are various methods to calculate this cost, but in this article, we will focus on the bond-yield-plus-risk-premium method. Let’s dive into this method and understand how it works.
Unlocking the Mystery: The Cost of Equity
The bond-yield-plus-risk-premium method is a popular way to calculate the cost of equity. This method takes into account the yield on long-term government bonds and adds a risk premium to it. The risk premium is calculated based on the company’s beta, which is a measure of its volatility compared to the market. The higher the beta, the higher the risk premium.
For example, if the yield on a long-term government bond is 5%, and the risk premium for a company with a beta of 1.5 is 6%, then the cost of equity for that company would be 11%. This means that shareholders would expect a return of 11% on their investment in that company.
Revealed Using the Bond-Yield-Plus-Risk-Premium Method
During the last few years, the cost of equity based on the bond-yield-plus-risk-premium method has been affected by various factors. One of the main factors is the low yield on long-term government bonds. This has led to a lower cost of equity for many companies. Additionally, the pandemic has caused volatility in the market, which has led to higher risk premiums for some companies.
Overall, the bond-yield-plus-risk-premium method is a useful tool for investors to estimate the cost of equity. It takes into account the risk and return expectations of shareholders and provides a fair valuation of a company’s stock. By using this method, investors can make informed decisions about which companies to invest in and at what price.
In conclusion, the bond-yield-plus-risk-premium method is an effective way to calculate the cost of equity. It considers the yield on long-term government bonds and the risk premium based on a company’s beta. While the cost of equity has been affected by various factors in recent years, this method remains a reliable tool for investors. By understanding the cost of equity, investors can make informed decisions about their investments and maximize their returns.
What is the cost of equity based on the bond-yield-plus-risk-premium method?
During the last few years, Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments. Recently, though, capital costs have been declining, and the company has decided to look seriously at a major expansion program that has been proposed by the marketing department. Assume that you are an assistant to Leigh Jones, the financial vice president. Your first task is to estimate Harry Davis’s cost of capital. Jones has provided you with the following data, which she believes may he relevant to your task:
(1) The firm’s tax rate is 40%.
(2) The current price of Harry Davis’s 12% coupon, semiannual payment, noncallable bonds with 15 years remaining to maturity is $1,153.72. Harry Davis does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.
(3) The current price of the firm’s 10%, $100 par value, quarterly dividend, perpetual preferred stock is $116.95. Harry Davis’s would incur flotation costs equal to 5% of the proceeds on a new issue.
(4) Harry Davis’s common stock is currently selling at $50 per share. Its last dividend (D0) was $4.19, and dividends are expected to grow at a constant rare of 5% in the foreseeable future. Harry Davis’s beta is 1.2, the yield on T- bonds is 7%, and the market risk premium is estimated to be 6%. For the bond-yield-plus risk-premium approach, the firm uses a 4 percentage point risk premium.
(5) Harry Davis’s target capital structure is 30% long-term debt, 10% preferred stock, and 60°/o common equity.
To structure the task somewhat, Jones has asked you to answer the following questions.
What is the cost of equity based on the bond yield plus risk premium method
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