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Assume that you are a consultant to XYZ Inc. and you have been provided with the following data:...

Question:

Assume that you are a consultant to XYZ Inc. and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant) .

What is the cost of equity from retained earnings based on the DCF approach?

a. 9.42%

b. 9.91%

c. 10.44%

d. 10.96%

e. 11.51%

Cost of Retained Earnings and Cost of New Stock:

The cost a firm's retained earnings is usually lower than the cost of new stock. This is because firms typically have to pay substantial flotation costs when raising equity capital using new stock issuance.

Answer and Explanation:

The answer is c.

According to the dividend growth model, the cost of equity is calculated as follows:

  • cost of equity = next dividend / current price + dividend growth rate
  • cost of equity = D1 / P0 + g
  • cost of equity = 0.67 / 27.50 + 8%
  • cost of equity = 10.44%

Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
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