In computing the cost of common equity, if D1 goes downward and Po goes up, Ke will
decrease.
To understand why, let's break down how the cost of common equity (Ke) is calculated using the Dividend Discount Model (DDM). The DDM is a method used to determine the value of a company's stock based on the present value of its future dividends.
The formula for calculating Ke using DDM is as follows:
Ke = (D1 / Po) + g
Where:
- D1 is the expected dividend for the next period.
- Po is the current price of the stock.
- g is the expected growth rate of dividends.
Now, let's consider the scenario you mentioned: D1 goes downward and Po goes up. This means that the expected dividend for the next period (D1) decreases, while the current price of the stock (Po) increases.
When D1 decreases, the numerator of the formula is lower, which results in a lower value for Ke. Similarly, when Po increases, the denominator of the formula is higher, further reducing the value of Ke.
Since the cost of common equity (Ke) is the required return on investment from shareholders' perspective, a decrease in Ke means that shareholders will demand a lower return on their investment. This can be interpreted as the perceived risk of investing in the stock decreasing, possibly due to higher market confidence or positive market sentiment.
In summary, if D1 goes downward and Po goes up, the cost of common equity (Ke) will decrease based on the calculations using the Dividend Discount Model.