Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^524) 15. Cost of Capital © The McGraw−Hill
Companies, 2002
Implementing the Approach To estimate REusing the dividend growth model ap-
proach, we obviously need three pieces of information: P 0 , D 0 , and g.^2 Of these, for a
publicly traded, dividend-paying company, the first two can be observed directly, so
they are easily obtained. Only the third component, the expected growth rate for divi-
dends, must be estimated.
To illustrate how we estimate RE, suppose Greater States Public Service, a large pub-
lic utility, paid a dividend of $4 per share last year. The stock currently sells for $60 per
share. You estimate that the dividend will grow steadily at a rate of 6 percent per year
into the indefinite future. What is the cost of equity capital for Greater States?
Using the dividend growth model, we can calculate that the expected dividend for the
coming year, D 1 , is:
D 1 D 0 (1 g)
$4 1.06
$4.24
Given this, the cost of equity, RE, is:
RED 1 /P 0 g
$4.24/60 .06
13.07%
The cost of equity is thus 13.07 percent.
Estimating g To use the dividend growth model, we must come up with an estimate
for g,the growth rate. There are essentially two ways of doing this: (1) use historical
growth rates, or (2) use analysts’ forecasts of future growth rates. Analysts’ forecasts are
available from a variety of sources. Naturally, different sources will have different esti-
mates, so one approach might be to obtain multiple estimates and then average them.
Alternatively, we might observe dividends for the previous, say, five years, calculate
the year-to-year growth rates, and average them. For example, suppose we observe the
following for some company:
We can calculate the percentage change in the dividend for each year as follows:
Year Dividend Dollar Change Percentage Change
1998 $1.10 ——
1999 1.20 $.10 9.09%
2000 1.35 .15 12.50
2001 1.40 .05 3.70
2002 1.55 .15 10.71
Year Dividend
1998 $1.10
1999 1.20
2000 1.35
2001 1.40
2002 1.55
496 PART SIX Cost of Capital and Long-Term Financial Policy
(^2) Notice that if we have D 0 and g, we can simply calculate D 1 by multiplying D 0 by (1 g).
Aggregate growth
estimates can be found at
http://www.zacks.com/earnings.