Question

Bunkhouse Electronics is a recently incorporated firm that makes electronic entertainment systems. Its earnings and dividends have been growing at a rate of 38.5%, and the current dividend yield is 10.50%. Its beta is 1.37, the market risk premium is 16.50%, and the risk-free rate is 2.30%.

A- use the CAPM to estimate the firms cost of equity.
B- Now use the constant growth model to estimate the cost of equity.

Answer 1

The cost of equity for Bunkhouse Electronics using CAPM is calculated to be 24.9%, while using the Constant Growth Model, it is calculated to be 49%.

Step-by-step explanation:

Estimating the Cost of Equity Using Different Models

To answer your question regarding Bunkhouse Electronics, we need to calculate the firm's cost of equity using two different methods: the Capital Asset Pricing Model (CAPM) and the Constant Growth Model (also known as the Dividend Discount Model).

A. Using CAPM to Estimate the Cost of Equity

The CAPM is expressed by the formula:
Cost of Equity = Risk-Free Rate + Beta * (Market Risk Premium).

Substituting the given values, we get:
Cost of Equity = 2.30% + 1.37 * (16.50%) = 2.30% + 22.60% = 24.9%.

B. Using the Constant Growth Model to Estimate the Cost of Equity

The Constant Growth Model is expressed by the formula:
Cost of Equity = (Dividend/Price) + Growth Rate

Given that the current dividend yield is 10.50%, and the growth rate is 38.5%, the cost of equity using this model would be:
Cost of Equity = 10.50% + 38.5% = 49%.

It's important to note that these models are based on several assumptions and the numbers should be used with caution.