The return on equity of KillerApps Inc.is 20% of which it pays out 30% as dividends and reinvests the rest in the company.The company is expected to pay a dividend of $1.50 next year and the current stock price is $30.The cost of equity of KillerApps is:
A)11.30%
B)19.00%
C)19.70%
D)30.00%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the Gordon Growth Model (Dividend Discount Model for a growing firm), which is given by: Cost of Equity = (D1 / P0) + g, where D1 is the dividend next year, P0 is the current stock price, and g is the growth rate of dividends (which equals the reinvestment rate times the return on equity). Here, the reinvestment rate is 70% (100% - 30% payout ratio), and the return on equity is 20%. Thus, the growth rate g = 0.70 * 20% = 14%. Plugging into the formula: Cost of Equity = ($1.50 / $30) + 14% = 0.05 + 14% = 19.50%. However, since 19.50% is not an option and considering the calculation might involve rounding, the closest option provided is 19.70%.

The Return on Equity of KillerApps Inc