Underestimated Inc.\'s common shares currently sell for $36 per share. The firm\

Question

Underestimated Inc.'s common shares currently sell for $36 per share. The firm's management believes that its shares should really sell for $54 per share. If the firm just paid an annual dividend of $2 per share and the firm expects those dividends to increase by 8 percent per year forever (and this is common knowledge to the market), what is the current cost of common equity for the firm and what does the firm believe is a more appropriate cost of common equity for the firm?

Current stock price $36

Firms expected stock price $54

Dividend just paid (D0) $2

Constant growth rate 8/5

Explanation / Answer

Stock Price = Dividend * (1+g) / (R-g)

36 = 2*(1+0.08) / (R-0.08)

R = 0.08+0.06 =0.14 or 14%

So, current cost of capital = 14%

Expected cost of capital

Expected Stock Price = Dividend * (1+g) / (R-g)

54 = 2*(1.08) / (R-0.08)

R = 0.12 OR 12%

More appropriate cost of equity = 12%

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