Underestimated Inc.’s common shares currently sell for $35 each. The firm’s mana
ID: 2751566 • Letter: U
Question
Underestimated Inc.’s common shares currently sell for $35 each. The firm’s management believes that its shares should really sell for $52 each. The firm just paid an annual dividend of $2 per share and management expects those dividends to increase by 5 percent per year forever (and this is common knowledge to the market).
What is the current cost of common equity for the firm?
What does management believe is the correct cost of common equity for the firm?
Cost of common equity (as per firm's belief)?Explanation / Answer
Given:-
Growth rate (g) = 5% per year
D0 = $2 per share
D1 = 2*1.05
= $2.10 per share
P0 = $35
..
According to Constant Growth DDM,
P0 = D1/(Re-g)
35 = 2.1/(Re-0.05)
Re-0.05 = 0.06
Re = 0.11
Re = 11%.
..
Cost of common equity (correct cost of common equity for the firm as per firm's belief)
P0 = 52
..
52 = 2.1/(Re-0.05)
Re-0.05 = 2.1/52
Re-0.05 = 0.0404
Re = 0.0904
Re = 9.04%
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