This answer results from increasing the estimated dividend at the end of the first year of $3.00 per share by 10%. The dividend to be used in the dividend growth model is the next dividend to be paid. In this question, the next dividend to be paid is $3.00, because that is the estimated dividend at the end of the first year. Therefore, it should not be increased by 10% to $3.30.
This is the growth rate of the dividend. It is also the amount of the dividend divided by the stock price. However, neither of these is the cost of equity capital for this firm. See the correct answer for a complete explanation.
The cost of common equity can be calculated with the following formula: d1 Cre = ---------------+ g P 0 Where: Cre = Cost of retained earnings d1 = The next dividend to be paid P0 = Common stock price today g = Annual expected % growth in dividends Note that the question says the estimated dividend at the end of the first year is $3.00 per share. Since the dividend is estimated, it is the next dividend to be paid and does not need to be adjusted upward. Inputting the information into this equation we get: 3 Cre = ---------------+ .10 = .20, or 20.0% 30
This answer results from increasing the estimated dividend of $3.00 by 10% and dividing the result ($3.30) by the stock price ($30). This is incorrect for two reasons: (1) The dividend to be used in the dividend growth model is the next dividend to be paid. In this question, the next dividend to be paid is $3.00, because that is the estimated dividend at the end of the first year. Therefore, it should not be increased by 10% to $3.30. And (2) after dividing the next dividend by the stock price, the result should be added to the expected growth rate to find the cost of common equity.
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