The Dividend Discount Model (DDM)

Correct. $$\displaystyle r_{e} = \frac{D_{1}}{P_{0}} + g$$ where the growth rate is the product of the company’s return on equity and its retention rate: $$\displaystyle g = 0.14 \times 0.65 = 0.091$$. So $$\displaystyle r_{e} =\frac{2.25}{59.25} + 0.091 = 0.129$$.

A firm will pay a dividend of USD 2.25 next year, has a retention ratio of 65%, return on equity of 14%, and a stock price of USD 59.25. Using the dividend discount model, the company’s cost of equity is _closest_ to:

Incorrect. This value is the growth rate, but not the cost of equity. The dividend discount model states that the intrinsic value of a share of stock is the present value of the share’s expected future dividends. Combine that idea with Gordon’s assumption of constant growth, and the cost of equity can be calculated, where the growth rate is the product of the company’s retention rate and its return on equity.

Incorrect. It’s possible that this answer was calculated by starting with a future-period dividend calculation. The firm will pay a dividend of USD 2.25 next year. This is already a forecasted value, so there is no need to grow this forward.

9.1%.

12.9%.

13.2%.