The constant-growth dividend discount valuation model states that the fair price of a share of common equity is determined by dividing next period's forecasted dividend by the difference between the cost of equity capital and the firm's long-term sustainable growth rate. Using this relationship, the cost of equity capital can alternatively be stated as:
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A. B. C.A
The constant-growth dividend discount valuation model, also known as the Gordon Growth Model, is used to estimate the fair price of a share of common equity. According to this model, the fair price is calculated by dividing the next period's forecasted dividend by the difference between the cost of equity capital and the firm's long-term sustainable growth rate.
To understand the alternative statement for the cost of equity capital, let's break down the components of the model:
Dividend (D): The dividend represents the cash flow distributed to shareholders by the company. In the constant-growth model, it is assumed that dividends will grow at a constant rate.
Cost of Equity Capital (r): This is the rate of return required by investors to hold the company's equity. It represents the opportunity cost of investing in the company's shares instead of alternative investments with similar risk profiles.
Long-term Sustainable Growth Rate (g): This is the expected rate at which the company's dividends will grow in the future while maintaining a stable and sustainable business model.
Based on the formula provided in the question, the fair price of a share of common equity (P) can be calculated as:
P = D / (r - g)
Now, let's examine the answer choices:
A. D/V + g: This formula does not align with the constant-growth dividend discount valuation model. It includes the ratio of debt to equity (D/V), which is unrelated to the cost of equity capital.
B. RFR-(+ RFR): This formula represents the risk-free rate (RFR) minus its sum (+ RFR). It does not correspond to the constant-growth model's calculation of the cost of equity capital.
C. Expected growth rate of dividends minus required rate of return: This option correctly represents the alternative statement for the cost of equity capital. In the formula P = D / (r - g), rearranging the equation, we can express the cost of equity capital (r) as:
r = g + (D / P)
This formula states that the cost of equity capital is equal to the expected growth rate of dividends (g) plus the dividend yield (D / P). The dividend yield is the ratio of the dividend to the current price of the share. Therefore, this option aligns with the constant-growth dividend discount valuation model.
Based on the above analysis, the correct answer is C. expected growth rate of dividends minus required rate of return.