Underestimated Inc. s common shares currently sell for $36 each. The firm's management believes...

Question:

Underestimated Inc. s common shares currently sell for $36 each. The firm's management believes that its shares should really sell for $54 each.

If the firm just paid an annual dividend of $2 per share and management expects those dividends to increase by 8 percent per year forever (and this is common knowledge to the market), what is the current cost of common equity for the firm and what does management believe is a more appropriate cost of common equity for the firm?

Cost of Equity:

The cost of equity is the rate of return investors require on the a firm's equity. According to the dividend discount model, the cost of equity is the sum of the stock's dividend yield and the stock's expected capital gains yield.

Answer and Explanation:

We can use the dividend growth model to compute the cost of equity as follows:

  • cost of equity = last dividend *(1 + dividend growth rate) / current price + dividend growth rate
  • cost of equity = 2 *(1 + 8%) / 36 + 8%
  • cost of equity = 14%

Given that the management believes the appropriate price is 54, the implied cost of equity is:

  • 2 *(1 + 8%) / 54 + 8% = 12%

Learn more about this topic:

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The Dividend Growth Model

from Finance 101: Principles of Finance

Chapter 14 / Lesson 3
9.7K

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