Question

# A company’s stock is currently selling for \$80 per share. The company has just paid a...

1. A company’s stock is currently selling for \$80 per share. The company has just paid a dividend of \$3.75 per share. Investors expect this dividend to grow at the rate of 9% per year for the next 8 years and at a rate of 3% per year thereafter.

1. Calculate the cost of equity for this company.

current stock price (P0) = \$80

dividend growth rate for first 8 years (g1) = 9%

From 9th year the dividend growth rate (g2) = 3%

Dt = dividend paid in year t

Dividend paid in year 0 i.e. today (D0) = \$3.75 per share

Dividend in year 1 = Dividend in year 0 + ( dividend in year 0 * growth rate * t )

D1 = D0 + ( D0 * g1 * 1)

= \$3.75 + (\$3.75 * 9% * 1)

= \$3.75 + \$0.3375

D1 = \$4.0875

Similarly, D8 = D0 + ( D0 * g1 * 8)

D8 = \$3.75 + (\$3.75 * 9% * 8)

D8 = \$3.75 + \$2.7

D8 = \$6.45

Therefore, dividend in year 8 (D8) = \$6.45

Cost of equity (Ke) using dividend growth model:

Ke = (Dividend / current stock price) + growth rate

= ( D8 / P0 ) + g2

= (\$6.45 / \$80) + 3%

= 0.080625 + 3%

= 8.0625% + 3%

Ke = 11.0625%

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