In a Gordon Growth Model, with D1 = $3 and P0 = $60 and growth rate g = 2%, what is the cost of equity?

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Study for the Finance and Investment Challenge Test. Approaches include flashcards and multiple-choice questions with hints and explanations. Ready yourself to ace the exam!

Multiple Choice

In a Gordon Growth Model, with D1 = $3 and P0 = $60 and growth rate g = 2%, what is the cost of equity?

Explanation:
In the Gordon Growth Model, the price today equals the next dividend divided by the cost of equity minus the growth rate: P0 = D1 / (ke - g). Solve for ke: ke = D1/P0 + g. Here, D1/P0 = 3/60 = 0.05, and g = 0.02, so ke = 0.05 + 0.02 = 0.07, or 7%. The cost of equity is 7% because investors expect a return of 7% given a $3 next-year dividend growing at 2% into perpetuity.

In the Gordon Growth Model, the price today equals the next dividend divided by the cost of equity minus the growth rate: P0 = D1 / (ke - g). Solve for ke: ke = D1/P0 + g. Here, D1/P0 = 3/60 = 0.05, and g = 0.02, so ke = 0.05 + 0.02 = 0.07, or 7%. The cost of equity is 7% because investors expect a return of 7% given a $3 next-year dividend growing at 2% into perpetuity.

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