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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Bharat Auto Ltd has just paid an annual dividend of Rs 10 per share. Dividends are expected to grow at 5% a year indefinitely. The ex-dividend share price is Rs 157.50. Using the dividend growth model, what is the cost of equity?

The cost of equity is about 11.7%. The dividend growth model uses next year's dividend of Rs 10.50 divided by the Rs 157.50 price, giving 6.67%, plus the 5% growth rate. Using the dividend just paid understates the result.

  1. A6.3%
  2. B11.3%
  3. C11.7%
  4. D12.0%Correct
  5. 16.7%

Explanation

Next dividend D1 = 10 x 1.05 = Rs 10.50. Ke = D1/P0 + g = 10.50/157.50 + 5% = 6.67% + 5% = 11.67%, about 11.7%. Using D0 instead of D1 gives 10/157.5 + 5% = 11.3%. The 6.3% option is D0/P0 alone.

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