Question

Cullumber Inc.’s common shares currently sell for $42 each. The firm’s management believes that its shares should really sell for $60 each. The firm just paid an annual dividend of $2 per share and management expects those dividends to increase by 5 percent per year forever (and this is common knowledge to the market).

What is the current cost of common equity for the firm? What is the appropiate cost of equity (as per firm belief)

Answer 1

8.5%

Step-by-step explanation:

Data provided in the question:

Current market price = $42 each

Firm's price = $60

Annual dividend paid = $2 per share

Growth rate = 5%

Now,

Cost of Common Equity

= [ Dividend Next Year ÷ Current Price ] + Dividend Growth Rate

and,

Dividend Next Year = $2 × (1 + 0.05) = $2.1

Therefore,

The current cost of common equity for the firm

= [ Dividend Next Year ÷ Market Price ] + Dividend Growth Rate

= [ $2.1 ÷ $42 ] + 0.05

= 0.1

or

= 0.1 × 100% = 10%

The appropiate cost of equity (as per firm belief)

= [ Dividend Next Year ÷ Firm's believed Price ] + Dividend Growth Rate

= [ $2.1 ÷ $60 ] + 0.05

= 0.085

or

= 0.085 × 100%

= 8.5%