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has a share price of $154 and an expected EPS of $8 next year. The company currently pays out 100% of earnings as dividends, but is considering a new policy of paying out just 70% of dividends. Retained earnings are expected to earn a return of 5.9%.What is the cost of equity?

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ahmedgodtrust

Answer:

Po = $154

EPS = $8

D1 = 70% x $8 = $5.6

r = 5.9% = 0.059

b = 30% = 0.3

g = b  x  r

g = 0.3 x  0.059

g = 0.0177  = 1.77%

Ke = D1/Po + g

Ke = $5.6/$154 + 0.0177

Ke  = 0.0541 = 5.41%

Explanation:

In this case, we need to calculate the growth rate by multiplying the rate of return(r) by the retention rate(b). Since the pay-out ratio is 70%, the retention rate(b) is 30%. Dividend is 70% of earnings per share. Then, we will calculate the cost of equity by dividing the expected dividend(D1) by the current market price of the share and thus add the growth rate.

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