Underestimated Inc.’s common shares currently sell for $31 each. The firm’s mana

Question

Underestimated Inc.’s common shares currently sell for $31 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? (Round intermediate calculations to 4 decimal places, e.g. 1.2514 and final answer to 2 decimal places, e.g. 15.25%.)

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

Current cost of common equity = D1/Ke-G

31 = 2(1+0.05)/Ke-0.05

31(Ke-0.05) = 2*1.05

31Ke - 1.55 = 2.10

31 Ke = 2.10+1.55

31 Ke = 3.65

Ke = 3.65/31 i.e 11.77%

Management beleives cost of equity to be

52 = 2( 1+0.05)/Ke-0.05

52( Ke - 0.05) = 2*1.05

52Ke-2.60 = 2.10

52Ke = 2.10+2.60

52 Ke = 4.70

Ke = 4.70/52 i.e 9.04%

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