HighGrowth Company has a stock price of $20. The firm will pay a dividend next year of $1.00, and its dividend is expected to grow at a rate of 4.0% per year thereafter. What is your estimate of HighGrowth's cost of equity capital? The required return (cost of capital) of levered equity is decimal place.) %. (Round to one
Dividend Valuation
Dividend refers to a reward or cash that a company gives to its shareholders out of the profits. Dividends can be issued in various forms such as cash payment, stocks, or in any other form as per the company norms. It is usually a part of the profit that the company shares with its shareholders.
Dividend Discount Model
Dividend payments are generally paid to investors or shareholders of a company when the company earns profit for the year, thus representing growth. The dividend discount model is an important method used to forecast the price of a company’s stock. It is based on the computation methodology that the present value of all its future dividends is equivalent to the value of the company.
Capital Gains Yield
It may be referred to as the earnings generated on an investment over a particular period of time. It is generally expressed as a percentage and includes some dividends or interest earned by holding a particular security. Cases, where it is higher normally, indicate the higher income and lower risk. It is mostly computed on an annual basis and is different from the total return on investment. In case it becomes too high, indicates that either the stock prices are going down or the company is paying higher dividends.
Stock Valuation
In simple words, stock valuation is a tool to calculate the current price, or value, of a company. It is used to not only calculate the value of the company but help an investor decide if they want to buy, sell or hold a company's stocks.
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**Estimating the Cost of Equity Capital**
**Question:**
HighGrowth Company has a stock price of $20. The firm will pay a dividend next year of $1.00, and its dividend is expected to grow at a rate of 4.0% per year thereafter. What is your estimate of HighGrowth’s cost of equity capital?
The required return (cost of capital) of levered equity is ________ %. (Round to one decimal place.)
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**Explanation:**
To estimate the cost of equity capital (required return on equity), we can use the Gordon Growth Model (Dividend Discount Model):
\[ R_E = \frac{D_1}{P_0} + g \]
Where:
- \(R_E\) is the cost of equity.
- \(D_1\) is the expected dividend next year.
- \(P_0\) is the current stock price.
- \(g\) is the constant growth rate of dividends.
Given the data:
- \(D_1 = $1.00\)
- \(P_0 = $20\)
- \(g = 4.0\% = 0.04\)
Plugging in these values:
\[ R_E = \frac{1.00}{20} + 0.04 \]
\[ R_E = 0.05 + 0.04 \]
\[ R_E = 0.09 \text{ or } 9.0\% \]
So, the estimated cost of equity capital for HighGrowth Company is **9.0%**.
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