ACCA Financial Management (F9) Certification Practice Exam

According to the Dividend Growth Model, how is the Cost of Equity (re) calculated?

1. g + (d0 x (1 + g) / P0)

2. d0 / P0 + g

3. (d0 x P0) / (g + 1)

4. (P0 - d0) / g

The correct answer is: g + (d0 x (1 + g) / P0)

In the context of the Dividend Growth Model, the Cost of Equity (re) is calculated using the formula that incorporates the expected dividends and their growth rate. The specific formula that accurately reflects this is: Cost of Equity (re) = (D1 / P0) + g Where: - D1 is the expected dividend next year, which can be expressed as d0 × (1 + g). - P0 is the current price of the stock. - g is the growth rate of the dividends. The option stating d0 / P0 + g represents the yield of dividends divided by the stock price, plus the growth rate of the dividends, which effectively gives the same result after adjusting for future dividends. Thus, the formula captures both the return from dividend yield and the expected growth, providing a comprehensive measure of the expected return required by equity investors. This approach is fundamental in finance, as it helps in understanding how dividends and their growth influence investor returns and informs decisions regarding stock valuation. It underscores the expectation of future payments by incorporating both current dividends and their anticipated growth, making it a robust method for estimating the cost of equity capital.