Suppose Stark Ltd. just issued a dividend of $1.92 per share on its common stock. The company paid dividends of $1.50, $1.65, $1.72, and $1.83 per share in the last four years.

Suppose Stark Ltd. just issued a dividend of $1.92 per share on its common stock. The company paid dividends of $1.50, $1.65, $1.72, and $1.83 per share in the last four years.

a.	If the stock currently sells for $40, what is your best estimate of the company’s cost of equity capital using the arithmetic average growth rate in dividends? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
a.	What if you use the geometric average growth rate? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Explanation:

To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was:

g1 = ($1.65 – 1.50)/$1.50 = .1000, or 10.00%

g2 = ($1.72 – 1.65)/$1.65 = .0424, or 4.24%

g3 = ($1.83 – 1.72)/$1.72 = .0640, or 6.40%

g4 = ($1.92 – 1.83)/$1.83 = .0492, or 4.92%

So, the average arithmetic growth rate in dividends was:

g = (.1000 + .0424 + .0640 + .0492)/4

g = .06389, or 6.389%

Using this growth rate in the dividend growth model, we find the cost of equity is:

RE = [$1.92(1.06389)/$40] + .06389

RE = .1150, or 11.50%

Calculating the geometric growth rate in dividends, we find:

$1.92 = $1.50(1 + g)4

g = .06366, or 6.366%

The cost of equity using the geometric dividend growth rate is:

RE = [$1.92(1.06366)/$40] + .06366

RE = .1147, or 11.47%