Cost of Equity Calculation: Discounted Cash Flow Approach

Calculating Cost of Equity using Discounted Cash Flow

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Question

Which of the following equations correctly illustrates the calculation of the cost of equity using the Discounted Cash Flow approach?

Answers

A. (Retention rate)*(ROE)

B. Last annual dividend/(1 + required rate of return)

C. Next annual dividend/current stock price

D. (1-tax rate)

E. (Next annual dividend/current stock price) + expected growth rate

F. (Last annual dividend/[expected return - required return])

G. expected growth rate

H. Risk-free rate of return + beta(expected return on the market - risk-free rate of return) E

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Explanations

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A. B. C. D. E. F. G. H.

Explanation

The Dividend-Yield-plus-Growth-Rate approach calls for the following components: next annual dividend, current stock price, and expected growth rate. This approach, also known as the Discounted Cash Flow (DCF) method, is a flexible and very adept tool in the hands of the financial analyst, and is it is imperative that the CFA candidate fully understand both the applications and the methodology of this approach. The fourth choice illustrates the Capital Asset Pricing Model, while the fifth represents an approach for calculating sustainable growth rate. The remaining answers are somewhat fictitious.

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