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CHAPTER 14 B-253 And using the dividend growth model, the cost of equity is R E = [\$1.60(1.06)/\$37] + .06 = .1058 or 10.58% Both estimates of the cost of equity seem reasonable. If we remember the historical return on large capitalization stocks, the estimate from the CAPM model is about two percent higher than average, and the estimate from the dividend growth model is about one percent higher than the historical average, so we cannot definitively say one of the estimates is incorrect. Given this, we will use the average of the two, so: R E = (.1180 + .1058)/2 = .1119 or 11.19% 4. To use the dividend growth model, we first need to find the growth rate in dividends. So, the increase in dividends each year was: g 1 = (\$1.12 – 1.05)/\$1.05 = .0667 or 6.67% g 2 = (\$1.19 – 1.12)/\$1.12 = .0625 or 6.25% g 3 = (\$1.30 – 1.19)/\$1.19 = .0924 or 9.24% g 4 = (\$1.43 – 1.30)/\$1.30 = .1000 or 10.00% So, the average arithmetic growth rate in dividends was: g = (.0667 + .0625 + .0924 + .1000)/4 = .0804 or 8.04% Using this growth rate in the dividend growth model, we find the cost of equity is: R E = [\$1.43(1.0804)/\$45.00] + .0804 = .1147 or 11.47% Calculating the geometric growth rate in dividends, we find: \$1.43 = \$1.05(1 + g) 4 g = .0803 or 8.03% The cost of equity using the geometric dividend growth rate is: R E = [\$1.43(1.0803)/\$45.00] + .0803 = .1146 or 11.46% 5. The cost of preferred stock is the dividend payment divided by the price, so: R P = \$6/\$96 = .0625 or 6.25% 6. The pretax cost of debt is the YTM of the company’s bonds, so:

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