Individual Cost Of Capital-Common Stocks(Part1of2)

May 17th, 2008 Comments off
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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

Methods To Compute Of Cost Of INTERNAL Common Equity

  • Dividend Growth Model
  • Capital Asset Pricing Model (CAPM)

Dividend Growth Model

  • The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return
  • Formula is Po = D1/(Ke-g)

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

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%

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