Question

A company wishes to know the cost of its equity, which is all in common stock. Use some or all of the following data to calculate Cost of Equity.

Take out to one decimal point. Show your work.

Cost of a share of stock: $38.00

Annual dividend per share of stock: $2.10

Tax rate: 35%

Interest rate on debt: 7.5%

Growth demand of investors: 8%.

Answer 1

Solution :

Cost of equity as per Constant Dividend Growth model:

As per the Dividend growth model value of a stock/share = D₀ * (1+g) / (K_e – g)

Where D₀ = Annual dividend per share

g = Growth rate /demand of investors

K_e = Cost of Equity

As per the Information given in the question:

D₀ = $ 2.10 ; g= 8 % ; Value of stock = $ 38 per share

Applying the above values in the formula for value of a stock as per the Dividend Growth model we have:

38 = 2.10 ( 1 + 0.08 ) / (K_e – 0.08)

38 = 2.10 ( 1.08 ) / (K_e – 0.08)

38 = 2.268 / (K_e – 0.08)

38 (K_e – 0.08) = 2.268

(K_e – 0.08) = 2.268 /38 = 0.0597

(K_e – 0.08) = 0.0597

K_e = 0.08 + 0.0597 = 0.1397

Thus, Cost of Equity as per Dividend growth model = 13.97 %.