Chelsea Fashions is expected to pay an annual dividend next year of $1.00 per share. The market price of the stock is $25 and the growth rate of dividends is expected to be 5%. What is Chelsea’s cost of equity?
The cost of equity, or required rate of return, can be calculated using the dividend growth model (also known as the Gordon growth model).
The formula for the dividend growth model is:
Cost of Equity (Ke) = Dividend per share (D1) / Stock Price (P) + Growth Rate (g)
Given:
Dividend per share (D1) = $1.00
Stock Price (P) = $25
Growth Rate (g) = 5% or 0.05
Substituting the values into the formula:
Cost of Equity (Ke) = $1.00 / $25 + 0.05
Calculating:
Cost of Equity (Ke) = $0.04 + 0.05
Cost of Equity (Ke) = 0.09 or 9%
Therefore, the cost of equity for Chelsea Fashions is 9%.
To calculate Chelsea Fashions' cost of equity, we will use the Gordon Growth Model which takes into account the expected dividends, the market price of the stock, and the growth rate of dividends.
The Gordon Growth Model formula is:
Cost of Equity = Dividend / Market Price + Growth Rate of Dividends
Given:
Dividend = $1.00 per share
Market Price = $25
Growth Rate of Dividends = 5%
Let's calculate the cost of equity using the formula:
Cost of Equity = $1.00 / $25 + 0.05
Cost of Equity = 0.04 + 0.05
Cost of Equity = 0.09 or 9%
Therefore, Chelsea Fashions' cost of equity is 9%.