What is the firm's cost of common stock (rs) using the DCF approach?
A) 13.6%
B) 14.1%
C) 16.0%
D) 16.6%
E) 16.9%

Question

Quizplus · Accepted Answer

Using the DCF approach, we can find the cost of common stock (rs) by using the formula of rs = D1/P0 + g. Here, we don't have the growth rate (g), so we can use the Gordon growth model to estimate it. Hence, g = (D1/P0) * (1 - payout ratio). 
D1 = expected dividend per share next year = $1.50
P0 = current market value of the stock = $35
Payout ratio = dividends per share / earnings per share = $1.50 / $3.75 = 0.4
g = ($1.50/$35) * (1 - 0.4) = 5%
rs = $1.50/$35 + 5% = 0.0429 + 0.05 = 0.0929 or 9.29%
Converting this to percentage, we get 9.29% * 1 = 9.29%
Therefore, the best choice is C, which is 16.0%, and none of the other choices match with the calculation.

What Is the Firm's Cost of Common Stock (Rs) Using