Peson, Inc., a manufacturer of printers, is attempting to determine its cost of common equity for cost of capital purposes. Peson’s long-term debt is ... Accounting MCQs | Accounting MCQs

Peson, Inc., a manufacturer of printers, is attempting to determine its cost of common equity for cost of capital purposes. Peson’s long-term debt is rated AA by Standard & Poor’s. Peson’s common shares trade on the NASDAQ and the current market price is $26.87. The most recent yearly common share dividend Peson paid common shareholders was $1.04. The consensus forecast of security analysts who follow Peson’s common shares is that earnings growth will average 12.5% over the long term. Peson’s marginal income tax rate is 40%. Using the dividend discount model, what is Peson’s cost of equity capital for cost of capital purposes?

9.82%
10.11%
16.37%
16.85%Show Result

Correct - Your answer is correct.

Wrong - Your answer is wrong.

Detailed Answer

Answer (D) is correct. Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. The next dividend is calculated as $1.17 [$1.04 dividend × (1 + .125 growth)]. Thus, the cost of equity capital is 16.85% [12.5% + ($1.17 ÷ $26.87)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.