Estimain Kce using the dividend discount model

CFA Level I Corporate Finance
#1

Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle’s after-tax cost of capital, an analyst’s estimate of Axle’s cost of common equity would be closest to:

A) 8.8%. B) 9.2%. C) 9.0%.

Your answer: B was correct!

We can estimate the company’s expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%

The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.’

For this question they reference SS 11 37h for follow up, but in that example they dont multiply the dividend by the growth rate. For example the book say it should be 2.40/40+ 3%. Should hte ending dividend be multiplied by the growth rate like the problem above or be left alone as the book says?

#2

The dividend payut ratio is the % of Net Income paid out as dividends (or, equivalently, DPS/EPS). So, they must both be measured as of the same time. In this problem, both DPS and EPS are as of time zero, so we can use them to det the plowback ratio. In the follow up, is the2.40 the most recent dividend or the next epxected one? In the formula, Kce = D(1)/P(0) + g.

#3

Oh I see what you’re saying. Yeah in the example they said the dividend would be paid next year, so growth rate wouldn’t be needed.