CA Intermediate · Financial Management and Strategic Management · Cost of Capital
Ganga Foods Ltd expects EPS of Rs 25 next year and pays out 60% of earnings as dividend. It earns 10% on retained funds, and the current share price is Rs 150. Using the Gordon model with growth derived from retention, what is the cost of equity?
The cost of equity is 14%. The expected dividend is 60% of Rs 25, which is Rs 15, giving a dividend yield of 10% on Rs 150. Growth equals the 40% retention ratio times the 10% return on retained funds, which is 4%. Adding yield and growth gives 14%.
- A10%
- B14%Correct
- C16%
- D20.67%
Explanation
D1 = 25 x 0.60 = Rs 15, so D1/P0 = 15/150 = 10%. Retention ratio = 40%, so g = 0.40 x 10% = 4%. Ke = 10% + 4% = 14%. Using the payout ratio for growth gives 6% and 16%, and using EPS instead of dividend gives 20.67%.
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