Suppose Stark Ltd. just issued a dividend of $2.57 per share on its common stock

Question

Suppose Stark Ltd. just issued a dividend of $2.57 per share on its common stock. The company paid dividends of $2.10, $2.31, $2.38, and $2.49 per share in the last four years.

If the stock currently sells for $60, 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. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

What if you use the geometric average growth rate? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Suppose Stark Ltd. just issued a dividend of $2.57 per share on its common stock. The company paid dividends of $2.10, $2.31, $2.38, and $2.49 per share in the last four years.

Explanation / Answer

To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was: g1 = (2.31-2.10)/2.10 = 0.1000 or 10%    g2 = (2.38-2.31)/2.31 = 0.0303 or 3.03% g3 = (2.49-2.38)/2.38 = .0462 or 4.62% g4 = (2.57-2.49)/2.49 = 0.0321 or 3.21% So, the average arithmetic growth rate in dividends was: g = (0.10+0.0303+0.0462+0.0321)/4 = 0.0522 or 5.22% Using this growth rate in the dividend growth model, we find the cost of equity is: RE = (2.57*(1+0.0522))/60 + 0.0522 = 0.0973 or 9.73% Calculating the geometric growth rate in dividends, we find: 2.57 = 2.10*(1 + g)^4   g = (2.57/2.10)^(1/4) - 1 g = 0.0518 = 5.18% The cost of equity using the geometric dividend growth rate is: RE = (2.57*(1+0.0518))/60 + 0.0518 = 0.0969 or 9.69%

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