Underestimated Inc.’s common shares currently sell for $35 each. The firm’s mana

Question

Underestimated Inc.’s common shares currently sell for $35 each. The firm’s management believes that its shares should really sell for $52 each. The firm just paid an annual dividend of $2 per share and management expects those dividends to increase by 5 percent per year forever (and this is common knowledge to the market).What is the current cost of common equity for the firm?What does management believe is the correct cost of common equity for the firm? (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)

Explanation / Answer

1)

Current cost of common equity for the firm = Expected Dividend/Share Price + growth rate

Current cost of common equity for the firm = 2*(1+5%)/35 + 5%

Current cost of common equity for the firm = 11%

2)

Correct cost of common equity for the firm = Expected Dividend/Share Price + growth rate

Correct cost of common equity for the firm = 2*(1+5%)/52 + 5%

Correct cost of common equity for the firm = 9.04%

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