There are two means of getting finance from common stocks namely:
- Retained earnings or internal common equity(Ke)
- External common equity (Kne)- the issuance of NEW common stocks.
Let’s see how we can compute the aforesaid’s cost of capital
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Methods To Compute Of Cost Of INTERNAL Common Equity
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Dividend Growth Model
Where Po = price of the stock today D1= dividend at the end of the first year Ke= required rate of return on equity g = constant growth rate of dividends If dividends are paid at a constant annual rate of growth(g) which is less than Ke: Ke= Dividend in year 1/Market price + Annual growth rate in dividends Therefore Ke(Required rate of return)= D1/Po + g |
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Illustration Using the DIVIDEND GROWTH MODEL BASIS Company XYZ Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3, compute the investors’ required rate of return using the Dividend Growth Model: Suggested Solution: Ke( Required rate of return) = D1/Po + g = $0.15(1+0.1) / $3 + 0.1 = $0.165/3+0.1 =0.155 =15.5% |