Question

The Drogon Co. just issued a dividend of $2.75 per share on its common stock. The company is expected to maintain a constant 5.7 percent growth rate in its dividends indefinitely. If the stock sells for $55 a share, what is the company’s cost of equity? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

The required rate of return or the cost of equity is 10.99 percent.

Step-by-step explanation:

The price of a stock whose dividends are growing at a constant rate can be calculated using the constant growth model of the Dividend discount model. This model bases the value of a stock on the present value of the expected future dividends from the stock. The formula for price under this method is,

Price today = D1 / r - g

Where,

• D1 is the dividend expected for the enxt period or D0 * (1+g)
• r is the cost of equity or required rate of return
• g is the growth rate in dividends

As we know the price of the stock today, the D0 and the growth rate in dividends, we can input the values of these variables into the formula to calculate the cost of equity.

55 = 2.75 * (1 + 0.057) / (r - 0.057)

55 * (r - 0.057) = 2.90675

55r - 3.135 = 2.90675

55r = 2.90675 + 3.135

r = 6.04175 / 55

r = 0.10985 or 10.985% rounded off to 10.99%