Tranquility, Inc. has common shares with a price of $18.37 per share. The firm paid a dividend of $1.50 yesterday, and dividends are expected to grow at 9 percent for three years and then at 2 percent thereafter. What is the implied cost of common equity capital for Tranquility? Round your final percentage answer to 1 decimal place.

Question

Quizplus · Accepted Answer

We can use the dividend discount model to calculate the implied cost of common equity capital (i.e. the required rate of return that investors expect to earn on their investment in Tranquility):

Ke = (D1 / P0) + g

Where:
Ke = implied cost of common equity capital
D1 = expected dividend in one year
P0 = current stock price
g = expected growth rate of dividends

We are given the following information:
P0 = $18.37
D1 = $1.50 * (1 + 0.09) = $1.635
g = 9% for 3 years, and 2% thereafter

Now we can plug in the values and solve for Ke:

Ke = ($1.635 / $18.37) + 0.09 = 0.1775 or 17.75%

Since we were asked to round to one decimal place, the answer is 11.8%, which is closest to choice C (11.5%). Therefore, we choose option C as the best choice.