A stock sells for $25. The next dividend will be $4 per share. If the return on

Question

A stock sells for $25. The next dividend will be $4 per share. If the return on equity ROE is a constant 15% and the company reinvests 40% of earnings in the firm, what must be the opportunity cost of capital? (Do not round intermediate calculations.)

A stock sells for $25. The next dividend will be $4 per share. If the return on equity ROE is a constant 15% and the company reinvests 40% of earnings in the firm, what must be the opportunity cost of capital? (Do not round intermediate calculations.)

Explanation / Answer

Stock price = D1÷(r-g)

D1 is next expected dividend

r is cost of capital

g is growth rate

Growth rate = ROE×Retention ratio

= 15%×40%

= 6%

Stock price = D1÷(r-g)

$25 = $4÷(r-6%)

Cost of capital, r = 22%

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