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The cost of capital

Question 8

Earnings retention model

An all equity financed company has made profits after taxation of $15,000 for
the year. It then pays out a dividend of $8,250. Opening capital was $50,000.

Assuming the company’s return on capital and its dividend payout ratio remains
the same, calculate the growth in dividends for next year.

g = b × r e

b = earnings retention rate = ($15,000 – $8,250)/$15,000 = 0.45 (or 45%)

r e = accounting rate of return = $15,000/$50,000 = 0.3 (or 30%)

g = 0.45 × 0.3 = 0.135 or 13.5%

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