Illustration of the Discounted Cash Flow Approach
by MaestroTo illustrate the DCF approach, suppose NCC’s stock sells for $32; its next expected
dividend is $2.40; and its expected growth rate is 7 percent.
Evaluating the Methods for Estimating Growth
Note that the DCF approach expresses the cost of common equity as the dividend yield (the expected dividend divided by the current price) and the growth rate. The dividend yield can be estimated with a high degree of certainty, but the growth estimate causes uncertainty as to the DCF cost estimate. We discussed three methods: (1) historical growth rates, (2) retention growth model, and (3) analysts’ forecasts. Of these three methods, studies have shown that analysts’ forecasts usually represent the best source of growth rate data for DCF cost of capital estimates.10
Bond-Yield-plus-Risk-Premium Approach
Some analysts use a subjective, ad hoc procedure to estimate a firm’s cost of common equity: they simply add a judgmental risk premium of 3 to 5 percentage points to the interest rate on the firm’s own long-term debt. It is logical to think that firms with risky, low-rated, and consequently high-interest-rate debt will also have risky, highcost equity, and the procedure of basing the cost of equity on a readily observable debt cost utilizes this logic.
Taken From : Credit Repair by Attorneys Robin Leonard and Deanne Loonin
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