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

Harlow Co has just paid a dividend of $0.40 per share. Dividends are expected to grow at 5% a year indefinitely. The current ex-dividend share price is $5.25. Using the dividend valuation model, what is Harlow's cost of equity?

The cost of equity is 13.0%. The dividend valuation model uses next year's dividend of $0.42 (0.40 x 1.05) divided by the $5.25 price, giving 8%, plus growth of 5%. Using the dividend just paid understates the cost.

  1. A12.6%
  2. B12.0%Correct
  3. C7.6%
  4. D13.0%

Explanation

Next year's dividend = 0.40 x 1.05 = 0.42. Ke = 0.42/5.25 + 0.05 = 0.08 + 0.05 = 13.0%. Wait: 0.42/5.25 = 0.08, so Ke = 13.0%. Option 12.6% uses 0.40/5.25 = 7.6% plus 5% (using the current dividend, not next year's).

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