Question

10 points Return to questionItem 3Item 3 10 points Suppose Stark Ltd. just issued a dividend of $2.24 per share on its common stock. The company paid dividends of $1.80, $1.98, $2.05, and $2.16 per share in the last four years. a. If the stock currently sells for $45, what is your best estimate of the company’s cost of equity capital using the arithmetic average growth rate in dividends? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) a. What if you use the geometric average growth rate? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Answer 1

Answer:

a. The  best estimate of the company’s cost of equity capital using the arithmetic average growth rate in dividends is 10.91%

a. The best estimate of the company’s cost of equity capital using the geometric average growth rate is 10.88%

Explanation:

a.

Time Dividend per share ($)     Growth

-4                       1.80  

-3                       1.98                      10.00%

-2                       2.05                       3.54%

-1                       2.16                        5.37%

0                       2.24                         3.70%

Average                                           5.65%

D0 = $ 2.24 / share

g = 5.65%  

D1 = D0 x (1 + g)

     = 2.24 x (1 + 5.65%)

      = $ 2.37

Current share price = P = $ 45 = D1 / (Ke - g)

The cost of equity = D1 / P + g

                                                 = 2.37 / 45 + 5.65%

                                                  = 10.91%

Therefore, The  best estimate of the company’s cost of equity capital using the arithmetic average growth rate in dividends is 10.91%

a. What if you use the geometric average growth rate?

A DPS of $ 1.80 / share 4 years back has given way to a DPS of $ 2.24 today.

CAGR, g = (2.24 / 1.80)1/4 - 1

               = 5.62%

D1 = 2.24 x (1 + g)

    = 2.24 x (1 + 5,62%)

    = $  2.37

cost of equity = D1 / P + g

                       = 2.37 / 45 + 5.62%

                        = 10.88%

Therefore, The best estimate of the company’s cost of equity capital using the geometric average growth rate is 10.88%