Question

Kimona Company hired you as a consultant to help estimate its cost of common equity. You have obtained the following data: D0 = $0.85; P0 = $20.00; and g = 5.00% (constant). The CEO thinks, however, that the stock price is temporarily depressed, and that it will soon rise to $40.00. Based on the DCF approach, by how much would the cost of common equity from retained earnings change if the stock price changes as the CEO expects?

Answer 1

-2.23%

Step-by-step explanation:

The formula to compute the cost of common equity under the DCF method is shown below:

= Current year dividend ÷ price + Growth rate

In first case,

The current dividend would be

= $0.85 + $0.85 × 5%

= $0.85 + $0.0425

= $0.8925

The other things would remain the same

So, the cost of common equity would be

= $0.8925 ÷ $20 + 5%

= 0.044625 + 0.05

= 9.46%

In second case,

The price would be $40

The other things would remain the same

So, the cost of common equity would be

= $0.8925 ÷ $40 + 5%

= 0.0223125 + 0.05

= 7.23%

The difference would be

= 7.23% - 9.46%

= -2.23%