Suppose a stock has a dividend of $0.90 per share, a growth rate of 12%, a current price of $31, and flotation costs of $3 per share. What would be the cost of this capital using the dividend yield model?

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Accepted Answer

[latex]Ke =\cfrac{\$ .90 imes(1+12 \%)}{\$ 31-\$ 3}+12 \%=\cfrac{\$ 1.008}{\$ 28}+12 \%=15.6 \%[/latex]

This is 0.3% higher than for existing equity (15.6% versus 15.3%), which doesn’t seem like much because most of the yield is embedded in the company’s growth rate. If the last dividend, Do, were $3.65 and the growth rate only 3%, the cost of existing common equity would be about the same.

[latex]Ke =\cfrac{\$ 3.65 imes(1+3 \%)}{\$ 31}+3 \%=\cfrac{\$ 3.76}{\$ 31}+3 \%=15.1 \%[/latex]

But the cost of new common equity shares would be significantly higher.

[latex]Ke =\cfrac{\$ 3.65 imes(1+3 \%)}{\$ 31-\$ 3}+3 \%=\cfrac{\$ 3.76}{\$ 28}+3 \%=16.4 \%[/latex]

The point is that these equations should not be used blindly. Judgment should be used in their application, and part of applying judgment is understanding how sensitive formulas will be to the facts of a particular situation.

Question 9.7: Suppose a stock has a dividend of $0.90 per share, a growth ...

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