The stock is expected to pay a dividend of $2.00 a share at the end of the year (D1 = $2.00), and the dividend is expected to grow at a constant rate of 4% a year. What is the cost of common equity?

Problem 9-5 cost of equity: dividend growth

he cost of common equity is a measure of the return investors expect to receive in exchange for investing in shares of Summerdahl Resort common stock. The cost of equity reflects the amount of risk associated with investing in the company’s equity, as well as potential returns that might be earned on those investments.

The formula used to calculate the cost of equity is: Cost of Equity = D1/(P0) + g, where D1 is equal to the expected dividend at the end of year one, P0 is equal to current share price and g equals expected growth rate. Applying this formula to Summerdahl Resorts gives us a cost of common equity equation that looks like this: Cost of Equity = $2/$28 + .04 = 14%. This means that for every dollar invested in a share of Summerdahl Resorts common stock an investor can expect to earn a return rate (or yield) equal to 14%.

This rate should be compared against other investment opportunities such as bonds or mutual funds so that investors can make prudent decisions when it comes time to invest their money. By comparing expected yields from different types and classes investments, investors have multiple points by which they can judge which type or class might best suit their needs.

Ultimately, understanding the cost or required return on investments allows potential investors determine whether potential gains outweigh any associated risks involved when investing in certain stocks, funds or bonds. It also provides insight into how much money companies must pay out each year just to maintain current market prices on their securities and/or attract new capital investments from shareholders and lenders alike.