Question

What are the assumptions underlying the use of a dividend growth model for the estimation of a company s cost of equity? Explain in details and give some examples

Answer 1

Following are the assumptions of Dividend growth model:

1. Entity has equity capital only and no debt capital is involved

2. IRR of the entity us contact

3. It is assumed that the entity has perpetual life

4.Retention ratio is assumed to be contact throughout

5. Growth rate is also constant

6. Ke is always greater that growth rate

7. Ke remains the constant .

Formula is as follows

Cost of equity (ke) ={[Do × (1+g)]/Po} + g

Example :

Current market price of ABC inc is $ 10

It has paid dividend of $ 1

Growth rate is 10%

Therefore

Ke = {[1×(1+0.1)]/10}+0.1

Ke = 0.21

i.e. Ke = 21%