Question

The cost of equity using the discounted cash flow (or dividend growth) approach Pierce Enterprises's stock is currently selling for $25.67 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firm's growth rate to be constant at 5.72%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Pierce's cost of internal equity? O 10.55% 11.66% 14.99% 11.10% Estimating growth rates It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate: • Carry forward a historical realized growth rate, and apply it to the future. • Locate and apply an expected future growth rate prepared and published by security analysts. • Use the retention growth model. Suppose Pierce is currently distributing 55% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 14%. Pierce's estimated growth rate is %.

Answer 1

1)

Cost of internal equity = (D1 / price) + growth rate

Cost of internal equity = (1.38 / 25.67) + 0.0572

Cost of internal equity = 0.053759 + 0.0572

Cost of internal equity = 0.1110 or 11.10%

2)

Growth rate = Retention ratio * ROE

Growth rate = (1 - 0.55) * 0.14

Growth rate = 0.45 * 0.14

Growth rate = 0.063 or 6.30%