Question

Suppose Stark Ltd. just issued a dividend of $2.33 per share on its common stock. The company paid dividends of $2.00, $2.08, $2.15, and $2.26 per share in the last four years. If the stock currently sells for $55, what is your best estimate of the company's cost of equity capital using the arithmetic average growth rate in dividends?What if you use the geometric average growth rate?

Answer 1

arithmetic average growth rate = (4% + 3.37% + 5.12% + 3.1%) / 4 = 3.9%

we need to find the required rate or return (RRR) in the following formula:

stock price = expected dividend / (RRR - growth rate)

• expected dividend = $2.33 x 1.039 = $2.42
• stock price = $55
• growth rate = 0.039

55 = 2.42 / (RRR - 0.039)

RRR - 0.039 = 2.42 / 55 = 0.044

RRR = 0.083 = 8.3%

geometric average growth rate = [(1.04 x 1.0337 x 1.0512 x 1.031)¹/⁴] - 1 = 3.89%

again we need to find the required rate or return (RRR) in the following formula:

stock price = expected dividend / (RRR - growth rate)

• expected dividend = $2.33 x 1.0389 = $2.42
• stock price = $55
• growth rate = 0.0389

55 = 2.42 / (RRR - 0.0389)

RRR - 0.0389 = 2.42 / 55 = 0.044

RRR = 0.0829 = 8.29%