Question

Summerdahl Resort's common stock is currently trading at $39.00 a share. The stock is expected to pay a dividend of $1.50 a share at the end of the year (D1 = $3.00), and the dividend is expected to grow at a constant rate of 5% a year. What is its cost of common equity?

Answer 1

The question is incorrect as the dividend at the end of the year is given at $1.5 which is also the D1. So the correct question is,

Summerdahl Resort's common stock is currently trading at $39.00 a share. The stock is expected to pay a dividend of $1.50 a share at the end of the year (D1 = $1.50), and the dividend is expected to grow at a constant rate of 5% a year. What is its cost of common equity?

Answer:

The cost of common equity is 8.85%

Explanation:

The constant growth model of DDM values a stock whose dividends are expected to grow at a constant rate indefinitely. The model calculates the value of the stock today based on the present value of the expected future dividends from the stock. The formula for price today under this model is,

P0 = D1 / (r - g)

Where,

• P0 is price today
• D1 is the dividend expected at the end of the year or Year 1
• r is the cost of equity
• g is the growth rate in dividends

Plugging in the values for all the available variables, we can calculate the value of r.

39 = 1.5 / (r - 0.05)

39 * (r - 0.05) = 1.5

39r - 1.95 = 1.5

39r = 1.5 + 1.95

r = 3.45 / 39

r = 0.08846 or 8.846% rounded off to 8.85%