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ACCA Applied Skills · Financial Management · Sources of finance and their relative costs

Dunmore Co's shares are priced at $4.00 ex-div. The dividend just paid was $0.30 and Dunmore retains 40% of earnings, earning a return of 10% on new investment. Using Gordon's growth approximation (g = retention x return), what is the cost of equity?

The cost of equity is 11.8%. Growth is retention of 40% times a 10% return, giving 4%. The next dividend is $0.312, a yield of 7.8% on $4.00, and adding 4% growth gives 11.8%.

  1. A11.5%
  2. B7.8%
  3. C11.8%Correct
  4. D12.0%

Explanation

g = 0.40 x 10% = 4%. Next dividend = 0.30 x 1.04 = 0.312. Ke = 0.312/4.00 + 0.04 = 0.078 + 0.04 = 11.8%. The 11.5% option uses 0.30/4.00 (7.5%) + 4%, ignoring growth in the dividend; 7.8% omits g.

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