Question

Rivoli Inc. hired you as a consultant to help estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from retained earnings?

Answer 1

Answer:

The cost of retained earnings is 11.84%

Explanation:

The discounted cash flow approach or dividend discount model is used to calculate the fair value of the stock based on the present value of the expected future dividends (cash flows) from the stock. The formula to calculate the value of the stock today is,

P0 = D0 * (1+g) / (r - g)

Where,

• D0 is the dividend today or the last dividend paid
• g is the growth rate in dividends
• r is the cost of equity or retained earnings

As we already know the D0, P0 and the growth rate in dividends, we can calculate the value of r or the cost of equity by putting in the available values for D0, P0 and g in the formula and solve it.

22.5 = 0.8 * (1+0.08) / (r - 0.08)

22.5 * (r - 0.08) = 0.864

22.5r - 1.8 = 0.864

22.5r = 0.864 + 1.8

r = 2.664 / 22.5

r = 0.1184 or 11.84%