The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I.Firms that have a 100 percent retention ratio
II.Firms that pay an unchanging dividend
III.Firms that pay a constantly increasing dividend
IV.Firms that pay an erratically growing dividend
A) I and II only
B) I and IV only
C) II and III only
D) I,II,and III only
E) I,III,and IV only

Question

Quizplus · Accepted Answer

The dividend growth model assumes that the dividend paid by a company grows at a constant rate. Therefore, it can be used to compute the cost of equity for firms that pay a constantly increasing dividend (III) and firms that pay an unchanging dividend (II). However, it cannot be used for firms that have a 100 percent retention ratio (I) because they do not pay any dividends. It also cannot be used for firms that pay an erratically growing dividend (IV) because the model assumes constant growth. Therefore, the best choice is II and III only, which is option C.

The Dividend Growth Model Can Be Used to Compute the Cost