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%
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Learn more about this topic:
from Finance 101: Principles of FinanceChapter 14 / Lesson 3