Cost of Equity Calculation | Intelligent Semiconductor | DCF Approach

Cost of Equity Calculation Using DCF Approach

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Question

Intelligent Semiconductor is considering issuing additional common stock. The firm has an after-tax cost of debt of 8.55%, with the yield to maturity on the firm's outstanding senior long-term debt at 13%. The company's combined federal/state income tax is 35%. The risk-free rate of return is 5.6%, and the annual return on the broadest market index is expected to be 13.5%. Shares of Intelligent Semiconductor have a historical beta of 1.6, and in the past, the firm has assumed a 265 basis point risk premium when calculating the cost of equity. The firm's next dividend is expected to be $0.50 per share, and the dividend has been growing at a

12% annual rate. Finally, the firm's common stock is priced at $24.78. What is the cost of equity for this firm using the Dividend-Yield-plus-Growth-Rate, or

Discounted Cash Flow (DCF) approach?

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Explanations

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A. B. C. D. E. F.

D

The cost of issuing common stock can be calculated using several methods, including the Bond-Yield- Plus-Risk-Premium approach, Discounted Cash Flow method, or by using the Capital Asset Pricing Model. In this example, you have been asked to calculate the cost of equity using the Discounted Cash Flow method, which is commonly referred to as the Dividend-Yield-plus-Growth-Rate approach. In calculating the cost of equity using this approach, the following components are necessary: next expected annual dividend, growth rate of dividends, and the current stock price. Everything else provided in this example is largely irrelevant. The calculation of the cost of equity using the DCF approach is as follows: {[next annual dividend $0.50 / common stock $24.78] + expected dividend growth rate 12%} = 14.018%.

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