The Dividend Discount Model (DDM)
An analyst gathered the following information about a company and the market.
| | | |
|--------|-------------------------------------------------|---|
| $28.00 | Current stock price of a common share | |
| $2.00 | Most recent dividend per share, paid | |
| 45% | Expected dividend payout rate | |
| 15% | Expected return of equity | |
| 1.5 | Beta | |
| 10% | Expected rate of return on the market portfolio | |
| 5% | Risk-free rate | |
Using the data above and the dividend discount model (DDM), what is the cost of equity _closest to_?
Correct!
$$\displaystyle \text{Expected growth rate} = (1 - 0.45) \times 0.15 = 0.0825 $$
$$\displaystyle \text{Expected Dividend Yield} = \frac{\$ 2}{\$ 28} \times (1 + 0.0825) = 0.0773 $$
$$\displaystyle \text{Cost of equity} = 0.0825 + 0.0773 = 0.1598 \approx 16 \% $$
Incorrect.
It's possible to calculate an answer of 14.375% by using the payout ratio in your calculations rather than the retention rate.
Incorrect.
It's possible to calculate an answer of 15.4% by forgetting to include a growth rate to the current dividend ratio to calculate the expected dividend ratio.
14%
15%
16%
