- CFA Exams
- CFA Level I Exam
- Study Session 10. Corporate Finance (1)
- Reading 33. Cost of Capital
- Subject 3. Cost of Common Equity

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**CFA Practice Question**

An analyst gathers the following information about a company and the market:

Most recent dividend per share paid on common stock: $2.40

Expected dividend payout rate: 40%

Expected return on equity (ROE): 15%

Beta for the common stock: 1.5

Expected return on the market portfolio: 12%

Risk-free rate of return: 4%

Current market price per share of common stock: $32.00

Most recent dividend per share paid on common stock: $2.40

Expected dividend payout rate: 40%

Expected return on equity (ROE): 15%

Beta for the common stock: 1.5

Expected return on the market portfolio: 12%

Risk-free rate of return: 4%

Using the dividend discount model approach, the cost of common equity for the company is closest to ______.

A. 16.4%

B. 17.2%

C. 18.1%

**Explanation:**According to the dividend discount model approach, the cost of common equity is equal to the dividend yield plus the growth rate. In this case, the growth rate is the earnings retention rate times the expected ROE or (1 - dividend payout rate) x expected ROE = 1 - 0.4) x 15% = 9%. The expected dividend = 2.40 x (1 + 0.09) = 2.616. The expected dividend yield = 2.616 / 32 = 8.175%. The cost of common equity = 8.175% + 9.0%.

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**User Contributed Comments**
3

User |
Comment |
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asalonga7 |
Tricking throwing in the beta and WACC figures in |

farhan92 |
I used the formula D/P +g g=(1-payout ratio)(ROE) However im not too sure why D was multiplied by 1.09 |

epfrndz |
If you don't multiply the last dividend by the growth rate (1.09), you'll get 16.5%. If you multiply the dividend by the growth rate you'll get 17.18%. |