CS Executive · Corporate Accounting and Financial Management · Cost of Capital
Under the dividend growth (Gordon) model, which expression gives the cost of equity share capital for a company whose next-year dividend is D1, current market price is P0 and constant growth rate is g?
The cost of equity under the dividend growth model is the expected next-year dividend divided by the current market price, plus the constant growth rate (Ke = D1/P0 + g), because shareholders' return comes from both dividend yield and growth.
- AD1 / P0 + gCorrect
- BD1 / P0 − g
- CD0 / P0 − g
- D(P0 / D1) + g
Explanation
Under the dividend growth model, cost of equity Ke = D1/P0 + g, where the dividend yield is based on the expected next-year dividend and the price today. Subtracting g understates the investors' required return, as the expected growth in dividends is part of the return they demand.
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