Cost of Equity Formula: Dividend Growth Model

The Dividend Growth Model calculates the cost of equity based on expected future dividends. It assumes dividends grow at a constant rate indefinitely.

Dividend Growth Model Equation

The fundamental formula is:

$ k_e = \frac{D_1}{P_0} + g $

Where:

• $k_e$ represents the Cost of Equity.
• $D_1$ is the expected dividend per share for the next period.
• $P_0$ is the current market price per share.
• $g$ is the constant expected growth rate of dividends.

The fraction $\frac{D_1}{P_0}$ is the expected Dividend Yield.

Analyzing the Options

Let's evaluate the given options based on the formula:

• Option 1:
  Retained Earning + Dividend yield
  - Incorrect. Retained earnings are not directly part of this specific cost of equity calculation.
• Option 2:
  Dividend yield + Expected Growth in Dividend
  - Correct. This directly corresponds to $\frac{D_1}{P_0} + g$.
• Option 3:
  Retained Earning + Expected Growth in Dividend
  - Incorrect. Retained earnings are reinvested but not directly added here.
• Option 4:
  Dividend yield + Intrinsic value
  - Incorrect. Intrinsic value is a related concept but not a component added to dividend yield for cost of equity in this model.

Final Answer Derivation

The Dividend Growth Model formula clearly states that the Cost of Equity ($k_e$) is the sum of the expected Dividend Yield ($\frac{D_1}{P_0}$) and the Expected Growth Rate in Dividends ($g$).