Question

aThe CEO of ABC Company asks you to assist with estimating of its cost of common equity. You have gathered the following data: D 0 = $0.85; P 0 = $22.00; and g L = 6.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the dividend growth model, by how much would the cost of common from reinvested earnings change if the stock price changes as the CEO expects? a. −1.66% b. −2.23% c. −2.03% d. −1.84% e. −1.49%

Answer 1

The current cost of equity is computed as shown below:

= [ (D0 x (1 + growth rate) / current price] + growth rate

= [ ($ 0.85 x 1.06) / $ 22 ] + 6%

= 10.09545455%

The new cost of equity is computed as shown below:

= [ (D0 x (1 + growth rate) / current price] + growth rate

= [ ($ 0.85 x 1.06) / $ 40 ] + 6%

= 8.2525%

So, the change in cost of equity will be as follows:

= 8.2525% - 10.09545455%

= - 1.84% Approximately

So, the correct answer is option d.

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