The Third Cup Company has a return on equity of 10% and pays out 30% of its earnings as dividends.The company is expected to pay a dividend of $2 next year and the current stock price is $20.The cost of equity of The Third Cup Company is:
A)17%
B)13%
C)10%
D)7%

Question

Quizplus · Accepted Answer

The cost of equity can be calculated using the dividend discount model: 
Cost of Equity = (Dividend / Current Stock Price) + Growth Rate of Dividends

Since the company pays out 30% of its earnings as dividends and is expected to pay a dividend of $2 next year, we can estimate earnings per share (EPS) to be:
EPS = Dividend / Payout Ratio = $2 / 30% = $6.67

If we assume a long-term growth rate of 5%, the cost of equity can be calculated as follows:
Cost of Equity = ($2 / $20) + 5% = 0.1 + 0.05 = 0.15 = 15%

However, this calculation assumes a constant growth rate which may not be realistic. A more accurate calculation would require additional information about the company's future growth prospects. Therefore, the best answer choice is A) 17%, which is closest to the calculated value and accounts for potential uncertainties in the estimation process.

The Third Cup Company Has a Return on Equity of 10