Final answer:
The correct answer to the student's question on calculating the cost of equity is 11.74%, which is obtained by using the Gordon Growth Model considering the current dividend payment, the growth rate of dividends,
Step-by-step explanation:
The correct answer is option 11.74%. To calculate the cost of equity for Castillo Corporation, which is essentially the return required by investors to compensate them for the risk of investing in the stock, we can use the Gordon Growth Model (also known as the Dividend Discount Model).
This model is represented by the formula:
Cost of Equity = (Dividends per share for next year / Current Stock Price) + Growth Rate of Dividends
Where the Dividends per share for next year is calculated as Current Dividends per Share * (1 + Growth Rate). Given that the company just paid $4.35 as its annual dividend and the dividends are increasing by 7.5 percent annually, we can calculate:
Dividends for next year = $4.35 * (1 + 0.075) = $4.67625
Thus, the cost of equity is calculated as follows:
Cost of Equity = ($4.67625 / $39.75) + 0.075 = 0.117656 + 0.075 = 0.1174 or 11.74%
The cost of equity is the expected rate of return that an investor requires from an investment in a company's stock. It represents the return that compensates for the risk associated with owning the stock.
To calculate the cost of equity, we can use the Gordon growth model:
Divide the annual dividend per share by the current stock price: $4.35 / $39.75 = 0.109">
Calculate the growth rate as a decimal by dividing the annual dividend growth rate by 100 and adding 1: (7.5/100) + 1 = 1.075
Subtract the growth rate from the required rate of return: 0.109 - 1.075 = 0.0825
Multiply the result by 100 to get the cost of equity as a percentage: 0.0825 * 100 = 8.25%
Therefore, the cost of equity for Castillo Corporation is 8.25%.