Financial Management · Sources of finance and their relative costs

Cost of Equity: Dividend Valuation Model and CAPM

Updated 11 October 2026 · Fact-checked

The cost of equity is the return shareholders require. The dividend valuation model gives ke = [D0(1 + g) ÷ P0] + g, using the current ex-div share price. CAPM gives ke = Rf + β(Rm − Rf), using the risk-free rate, equity beta and market premium. Pick the model that matches the data given.

Understand Cost of Equity: Dividend Valuation and CAPM

The cost of equity is the return shareholders demand for holding a company's shares. You cannot read it off a bill like loan interest. You must estimate it from market data. For the company it is the minimum return new projects must earn to keep shareholders satisfied.

The dividend valuation model (DVM) says a share price equals the present value of its future dividends. If dividends grow at a constant rate g forever, the price is P0 = D0(1 + g) ÷ (ke − g). Rearrange it and you get ke = [D0(1 + g) ÷ P0] + g. The first part is the dividend yield on next year's dividend. The second part is the growth shareholders expect.

The growth rate g is rarely given. You estimate it from history: g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1, where n is the number of years of growth, not the number of dividends. Or you use the Gordon growth model: g = b × r, where b is the proportion of earnings retained and r is the return on those retained funds.

The capital asset pricing model (CAPM) takes a different view. It links required return to systematic risk, the risk that cannot be diversified away. Shareholders are paid for the risk they cannot remove. The equity beta (β) measures how much the share moves relative to the market. A beta of 1 means the share moves with the market. Above 1 means more volatile. Below 1 means less volatile.

The DVM needs dividend and price data and a growth assumption. CAPM needs market data and a beta. CAPM allows for risk directly, so it suits changing risk. The DVM is weak when growth is unstable or no dividends are paid. CAPM is weak because beta and the premium are estimates from past data. In an exam, use the model whose inputs you are given.

Key rules to remember

Dividend valuation model (constant growth): P0 = D0(1 + g) ÷ (ke − g); P0 must be the ex-div price. It holds only when ke > g and growth is constant.
Cost of equity from DVM: ke = [D0(1 + g) ÷ P0] + g; D0 is the dividend just paid. Use D1 directly if given.
Dividend growth from history: g = (D latest ÷ D earliest)^(1 ÷ n) − 1; n is the number of growth periods, which is one fewer than the number of dividends.
Gordon growth estimate: g = b × r; b is the retention rate. r is the return on retained funds, often ROCE or return on equity.
CAPM: ke = Rf + β(Rm − Rf); (Rm − Rf) is the equity risk premium. If you are given Rm, subtract Rf first.
Ex-div adjustment: Ex-div price = cum-div price − dividend about to be paid; Make this adjustment before using the DVM.

How to solve Cost of Equity: Dividend Valuation and CAPM questions

Use this method for any cost of equity question.

1Read the data. Decide which model fits: dividends and share price point to the DVM, beta and market returns point to CAPM.
2For the DVM, check the share price is ex-div. If it is cum-div, subtract the dividend due.
3Find g. Use the stated growth rate, or calculate it from past dividends, or use b × r.
4Make sure the dividend is next year's: D1 = D0(1 + g). Do not grow it twice if D1 is already given.
5Substitute into ke = D1 ÷ P0 + g, or into ke = Rf + β(Rm − Rf).
6Keep working in decimals and round only at the end. Express ke as a percentage.
7If asked, comment briefly on the model's limits or compare the two answers.

Quickest way: Pick the model and plug in

When to use it: Use this in Section A or B objective questions, where you have about 3 minutes per two-mark question.

Scan for the key words: beta or market return means CAPM; dividend and price means DVM.
For CAPM, write Rf + β × premium and compute directly. Check whether the premium or the market return is given.
For the DVM, compute D1 = D0 × (1 + g), divide by P0, add g.
Check for traps: cum-div price, growth over n years, and a premium versus a market return.
Do a sense check. A cost of equity below the cost of debt is almost certainly an error.

Common mistakes in Cost of Equity: Dividend Valuation and CAPM

Using D0 instead of D1 in the DVM.
The formula looks like dividend ÷ price, so students use the dividend they are given.
Fix: Always ask whether the dividend is the one just paid (D0). If so, multiply by (1 + g) first.
Using a cum-div share price without adjustment.
Students ignore the wording about the dividend being about to be paid.
Fix: Subtract the imminent dividend to get the ex-div price before calculating.
Using the wrong number of years when calculating g.
Students count the number of dividends rather than the intervals between them.
Fix: Dividends for 5 years give 4 growth periods. Use the 4th root.
Putting the market return in place of the risk premium in CAPM.
Both numbers are called returns and appear in similar questions.
Fix: The bracket is (Rm − Rf). If the question gives Rm, subtract Rf. If it gives the premium, use it as it stands.
Applying g = b × r with the wrong inputs, such as the payout ratio instead of the retention rate.
Dividend payout and retention are easily confused.
Fix: b = 1 − payout ratio. Write out b before multiplying.
Mixing up asset beta and equity beta.
Both are betas, and gearing is mentioned in the question.
Fix: CAPM for the cost of equity needs the equity beta. Use the asset beta only when the question asks you to ungear and regear.

Worked examples

Example 1

Trent Co has just paid a dividend of $0.40 per share. Its dividends five years ago were $0.30 per share. The current ex-div share price is $5.20. Calculate the cost of equity using the dividend valuation model, assuming past growth continues.

Show the solution

Growth over 5 years: g = (0.40 ÷ 0.30)^(1 ÷ 5) − 1.
0.40 ÷ 0.30 = 1.3333. The fifth root of 1.3333 is about 1.0592.
So g = 5.92%, using 0.0592.
D1 = 0.40 × 1.0592 = 0.4237.
Dividend yield = 0.4237 ÷ 5.20 = 0.0815.
ke = 0.0815 + 0.0592 = 0.1407, or 14.1%.

Answer: The cost of equity is approximately 14.1%.

Example 2

Delta Co has an equity beta of 1.2. The risk-free return is 4% and the market return is 11%. Delta's latest dividend is $0.50 and its cum-div price is $4.60 with a dividend of $0.50 about to be paid. It retains 40% of earnings and earns 15% on retained funds. (a) Calculate the cost of equity using CAPM. (b) Calculate the cost of equity using the DVM with the Gordon growth estimate of g.

Show the solution

(a) Equity risk premium = 11% − 4% = 7%.
ke = 4% + 1.2 × 7% = 4% + 8.4% = 12.4%.
(b) Ex-div price = 4.60 − 0.50 = $4.10.
g = b × r = 0.40 × 0.15 = 0.06, or 6%.
D1 = 0.50 × 1.06 = $0.53.
Dividend yield = 0.53 ÷ 4.10 = 0.1293.
ke = 0.1293 + 0.06 = 0.1893, or 18.9%.

Answer: CAPM gives 12.4%. The DVM gives about 18.9%. The gap shows the sensitivity of the DVM to its growth and price inputs.

Exam tips

Highlight whether the price is cum-div or ex-div before you start calculating. This is a favourite trap in objective questions.
Objective questions are all or nothing, so write each step on your workings sheet. Do not do the growth and yield in your head.
In constructed response questions, show the formula, the inputs and the result. Method marks are available even if an input is wrong.
If asked to compare models, mention that CAPM allows explicitly for systematic risk, while the DVM depends on a reliable growth estimate.
Use the equity risk premium and risk-free rate exactly as given. Do not substitute your own figures.

Practice questions from Sources of finance and their relative costs

Cost of Equity: Dividend Valuation and CAPM in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Equity: Dividend Valuation and CAPM: frequently asked questions

What is the difference between the dividend valuation model and CAPM?

The DVM derives the cost of equity from dividends, share price and expected growth. CAPM derives it from the risk-free rate, the equity beta and the market risk premium. CAPM explicitly reflects systematic risk, while the DVM relies on a growth estimate.

How do I calculate g for the dividend growth model?

Either use the past dividends: g = (latest ÷ earliest)^(1 ÷ n) − 1, where n is the number of years of growth. Or use the Gordon estimate g = b × r, where b is the retention rate and r is the return on retained funds.

Do I use D0 or D1 in the DVM?

The formula needs next year's dividend, D1. If you are given the dividend just paid (D0), multiply it by (1 + g). If D1 is stated, use it directly.

Why must the share price be ex-div?

The model values the dividends still to be received. A cum-div price includes a dividend that is about to be paid, so the buyer would not get it later. Subtract it to get the ex-div price.