What is the impact of using cost of equity in a dividend discount model?

Using the cost of equity in a dividend discount model (DDM) plays a crucial role, as it directly influences the discounting process of the expected future dividends to determine the stock price. The DDM operates on the principle that the value of a stock is the present value of all future expected dividends.

The cost of equity represents the return required by investors to compensate for the risk of owning the stock. When calculating the present value of future dividends, the cost of equity is utilized as the discount rate. This means that higher expected returns (cost of equity) will lead to a lower present value of future dividends, and consequently, a lower stock price, all else being equal. Conversely, a lower cost of equity would result in a higher present value of those dividends and a higher estimated stock price.

This foundational mechanism underlines why the correct choice focuses on the role of the cost of equity in determining the stock price by discounting the expected future dividends. The other options do not accurately capture the essence of the DDM and the significance of the cost of equity in this context.