Question

cost of ordinary shares: two-stage rocket's ordinary shares just paid an annual dividend equal of $1.30 and it is commonly known that the company expects dividends paid toincrease by 9.40 percent for the next two years and by 2% thereafter. if the current price of two-stages ordinary shares is $12.21, then what is the cost of equity capital for the company?

Answer 1

Given about Rocket's ordinary shares,

Last dividend paid D0 = $1.30

dividends are expected to increase at the rate of 9.40% for next two years

=> D1 = D0*1.094 = 1.3*1.094 = $1.4222

D2 = D1*1.094 = 1.4222*1.094 = $1.5559

thereafter, dividend will grow at a rate of g = 2%

=> D3 = D2*(1+g) = 1.5559*1.02 = 1.5870

let cost of equity be Ke

So, stock price at year 2 using constant dividend growth model is

P2 = D3/(Ke-g) = 1.5870/(Ke-0.02)

current stock price P0 = $12.21

So, current price of stock is sum of PV of future dividends and P2 discounted at Ke

=> P0 = D1/(1+Ke) + D2/(1+Ke)^2 + P2/(1+Ke)^2

=> 12.21 = 1.4222/(1+Ke) + 1.5559/(1+Ke)^2 + 1.5870/((Ke-0.02)*(1+Ke)^2)

Solving this equation, we get Ke = 14.40%

So, the cost of equity capital for the company is 14.40%