In October, 2025 AB Co.'s share was sold for 146 per share. A long term earnings growth rate of 7.5% is anticipated. AB Co. is expected to pay…

(i) According to Dividend Discount Model approach the firm's expected or required return on equity is computed as follows: Ke = (D1 / P0) + g Where, Ke = Cost of equity share capital D1 = Expected dividend at the end of year 1 P0 = Current market price of the share. g = Expected growth rate of dividend. Therefore, Ke = (3.36 / 146) + 7.5% = 0.0230 + 0.075 = 0.098 Or, Ke = 9.80% (ii) With rate of return on retained earnings (r) 10% and retention ratio (b) 60%, new growth rate will be as follows: g = br = 0.10 X 0.60 = 0.06 Accordingly, dividend will also get changed and to calculate this, first we shall calculate previous retention ratio (b1) and then EPS assuming that rate of return on retained earnings (r) is same. With previous Growth Rate of 7.5% and r =10% the retention ratio comes out to be: 0.075 = b1 x 0.10 b1 = 0.75 and payout ratio = 0.25 With 0.25 payout ratio the EPS will be as follows: EPS = 3.36 / 0.25 = 13.44 With new 0.40 (1 – 0.60) payout ratio the new dividend will be D1 = 13.44 X 0.40 = 5.376 Accordingly new Ke will be Ke = (5.376 / 146) + 6.0% Ke = 9.68%