Question

ABC's expected dividend next year is $2.50 per share. They have maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 4%. Roland's A-rated bonds are yielding 9%, and its current stock price is $30. What is the estimated cost of UWY’s retained earnings, rs?

Answer 1

Expected Dividend next year (D1) = $2.50

EPS 7 years ago = $1.50

Dividend payout ratio during that time = 50%

Dividend 7 years ago = EPS*Dividend payout ratio

= $1.50*50%

= $0.75

Growth rate(g) = (Present dividend/Past Dividend)^1/n - 1

= (2.50/0.75)^1/8 - 1

= 16.24%

Current Price(P0) = $30

Calculatiing the Cost of Retained earnings using Dividend Growth model:-

rs = (D1/P0) + g

= (2.50/30) + 0.1624

= 24.57%

So, the estimated cost of UWY’s retained earnings, rs is 24.57%

Note- Cost of Retained earnings are always calculated using Dividend Growth model.

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