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Solving for Ke: At the end of 1994, the price of Adam Mills' stock was around \$14, and earnings per share for 1994 were \$1.28

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I need help with a problem that I have the solution to but need to know how it's done so I can study for a test:

Annual dividends for Adams Mills are as follows:
year 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
div. .00 .10 .10 .10 .10 .10 .10 .12 .15 .17 .21

At the end of 1994, the price of Adam Mills' stock was around \$14, and earnings per share for 1994 were \$1.28. The risk-free rate was 7% and the Beta was .90. Estimate the cost of equity (Ke) using the dividend growth model, the earnings yield model, and CAPM (assume a 5% market risk premium).

I only need help with the dividend growth model. I correctly calculated the growth rates (g) but can't get the cost of equity (Ke).
The growth rates are as follows:
year 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
g in% n/a 8.59 9.72 11.18 13.16 16.00 20.38 20.51 18.32 23.53
Ke in% n/a 10.22 11.36 12.85 14.86 17.74 22.19 22.31 20.10 25.38

How did they get Ke? The formula Ke=(D1/P0)+g doesn't seem to be helping me. Am I wrong to be using \$14 for P0? What else would I use?

Solution Preview

The growth rate (g) can be estimated in a number of ways.
i) Using the company's historical average growth rate.
ii) Using an industry median or average growth rate.
iii) Using the sustainable growth rate.
In this question since you have been given the historical dividends, historical dividend growth rate is the appropriate method.

While estimating growth rate based on historical dividends we are assuming that the dividends will grow at the same rate as it has been doing in the past. There are several options available to you for calculting the value of g. For calculating average ...

Solution Summary

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\$2.49