Question

Eastern Electric currently pays a dividend of about $176 per share and sells for $35 a share. a. If Investors believe the growth rate of dividends is 2% per year, what is the opportunity cost of capital? (Do not round Intermediate calculations. Round you answer to 2 decimal places.) Cost of Capital b. If Investors' opportunity cost of capital is 10%, what must be the growth rate they expect of the firm? (Do not round Intermediate calculations. Round your answer to 2 decimal places.) Growth rate c. If the sustainable growth rate is 4% and the plowback ratio is 2. what must be the return on equity ROE? (Round your answer to 2 decimal places.) ROE

Answer 1

Ans :

(a)

According to Gordon Growth Model,

P = D1 / (r-g)

r = (D1/P) + g

P = Current stock price = $35

r = cost of capital = ?

g = growth rate = 2%

D1 = Dividend payable one year from now = D0*(1+growth rate)

= $ 1.76*(1+2%)

= $ 1.76*(1.02)

= $ 1.7952

Insert above data in the formula,

r = (D1/P) + g

= ($ 1.7952 / 35) + 2%

= 0.0512914 + 0.02

= 0.0712914

= 7.13%

(b) P = D1 / (r-g)

P = D0*(1+g) / (r-g)

P*(r-g) = D0 + D0g

P*r - Pg = D0+D0g

(P*r-D0) = D0g + Pg

(P*r -D0 ) / (D0+P) = g

P = $ 35

D0 = 1.76

r = 10%

g = (35*0.1 - 1.75) / (1.75+35)

= (3.5-1.75) / (36.75)

= 1.75 / 36.75

= 0.047619

= 4.76 %

(c) growth rate (g) = 4%

Plowback ratio = 0.2

ROE = growth rate*plowback ratio

= 4% *0.2

= 0.8 %