The Electricity Regulatory Commission is in the process of estimating cost of equity for electric companies. The commission regulates the price per unit of electricity the electric company can charge and hence the return on equity (assuming that expenses are constant or increase in a definite fashion). The idea is to add a constant spread to the cost of equity to calculate the allowable return on equity and work backwards to calculate price per unit. The Commission decided to use the Gordon Model. The model requires estimation of constant dividend growth in the long run. Either the historic dividend growth rate or a forecast might be used. The officials reasoned that the growth rate in earnings and dividends is a function of: CPI inflation, yield on long term T-bond and growth rate in GDP. Using macroeconomic data the commission obtained the following regression results:
Divgro = 0.9671 + 0.7028 CPI inflation
The other factors were found to be uncorrelated. If the forecast of inflation is 7 percent, what is the expected growth rate in dividends? Do you think this method is appropriate for other types of businesses?
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