2. The Cost of Capital: Cost of Retained Earnings The cost of common equity is based...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
2. The Cost of Capital: Cost of Retained Earnings The cost of common equity is based on the rate of return that investors require on the company's common stock. New common equity is raised in two ways: (1) by retaining some of the current year's earnings and (2) by issuing new common stock. Equity raised by issuing stock has a(n) -Select- cost, re, than equity raised from retained earnings, rs, due to flotation costs required to sell new common stock. Some argue that retained earnings should be "free" because they represent money that is left over after dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still has a cost, a(n) -Select- cost. The firm's after-tax earnings belong to its stockholders, and these earnings serve to compensate them for the use of their capital. The earnings can either be paid out in the form of dividends to stockholders who could have invested this money in alternative investments or retained for reinvestment in the firm. Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk. If the firm cannot invest retained earnings to earn at least rs, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return. There are three procedures that can be used to estimate the cost of retained earnings: the Capital Asset Pricing Model (CAPM), the Bond-Yield-Plus-Risk-Premium approach, and the Discounted Cash Flow (DCF) approach. CAPM The firm's cost of retained earnings can be estimated using the CAPM equation as follows: Ts TRF (RPM) b = TRF + (TM-TRF)bi The CAPM estimate of rs is equal to the risk-free rate, RF, plus a risk premium that is equal to the risk premium on an average stock, (TM - TRF), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, bi. This model assumes that a firm's stockholders are -Select- diversified, but if they are -Select- diversified, then the firm's true investment risk would not be measured by -Select- and the CAPM estimate would -Select- Bond Yield Plus Risk Premium the correct value of rs. If reliable inputs for the CAPM are not available as would be true for a closely held company, analysts often use a subjective procedure to estimate the cost of equity. Empirical studies suggest that the risk premium on a firm's stock over its own bonds generally ranges from 3 to 5 percentage points. The equation is shown as: r = Bond yield + Risk premium. Note that this risk premium is -Select- the risk premium given in the CAPM. This method doesn't produce a precise cost of equity, but does provide a ballpark estimate. DCF The DCE approach for estimated the cost of retained earnings r is given as follows: 2. The Cost of Capital: Cost of Retained Earnings The cost of common equity is based on the rate of return that investors require on the company's common stock. New common equity is raised in two ways: (1) by retaining some of the current year's earnings and (2) by issuing new common stock. Equity raised by issuing stock has a(n) -Select- cost, re, than equity raised from retained earnings, rs, due to flotation costs required to sell new common stock. Some argue that retained earnings should be "free" because they represent money that is left over after dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still has a cost, a(n) -Select- cost. The firm's after-tax earnings belong to its stockholders, and these earnings serve to compensate them for the use of their capital. The earnings can either be paid out in the form of dividends to stockholders who could have invested this money in alternative investments or retained for reinvestment in the firm. Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk. If the firm cannot invest retained earnings to earn at least rs, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return. There are three procedures that can be used to estimate the cost of retained earnings: the Capital Asset Pricing Model (CAPM), the Bond-Yield-Plus-Risk-Premium approach, and the Discounted Cash Flow (DCF) approach. CAPM The firm's cost of retained earnings can be estimated using the CAPM equation as follows: Ts TRF (RPM) b = TRF + (TM-TRF)bi The CAPM estimate of rs is equal to the risk-free rate, RF, plus a risk premium that is equal to the risk premium on an average stock, (TM - TRF), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, bi. This model assumes that a firm's stockholders are -Select- diversified, but if they are -Select- diversified, then the firm's true investment risk would not be measured by -Select- and the CAPM estimate would -Select- Bond Yield Plus Risk Premium the correct value of rs. If reliable inputs for the CAPM are not available as would be true for a closely held company, analysts often use a subjective procedure to estimate the cost of equity. Empirical studies suggest that the risk premium on a firm's stock over its own bonds generally ranges from 3 to 5 percentage points. The equation is shown as: r = Bond yield + Risk premium. Note that this risk premium is -Select- the risk premium given in the CAPM. This method doesn't produce a precise cost of equity, but does provide a ballpark estimate. DCF The DCE approach for estimated the cost of retained earnings r is given as follows:
Expert Answer:
Posted Date:
Students also viewed these finance questions
-
In Exercises, analyze and sketch a graph of the function. Label any intercepts, relative extrema, points of inflection, and asymptotes. Use a graphing utility to verify your results. f(x)=x16 - x
-
Roebuck Industries produces two electronic decoders, P and Q. Decoder P is more sophisticated and requires more programming and testing than does Decoder Q. Because of these product differences, the...
-
A sociologist samples five families in a certain town and records their annual income. The incomes are $34,000, $57,000, $13,000, $1,200,000, and $62,000. In Exercises 19 and 20, identify the...
-
Preparing a Statement of Financial Position} Refer to the information for Sparrow Company above. \section*{Required:} Prepare a classified statement of financial position for Sparrow at December 31,...
-
Reggi Vineyards produces a full line of varietal wines. The company, whose fiscal year begins on November 1, has just completed a record-breaking year. Its inventory account balances on October 31 of...
-
The function f(x) = 2 + 8x + 200x * has one local minimum and one local maximum. This function has a local maximum at @ = with value and a local minimum at a = with value Question Help: Video
-
At the beginning of the year, a company estimated that 20,000 direct labor-hours would be required for the period's estimated level of production. The company also estimated $140,000 of fixed...
-
Why is it necessary to serve nonparty witnesses with a subpoena to appear at trial?
-
Jill Corp is subject to tax in only one state. During the year, it generated the following: Federal taxable income is $1,200,000. What is the corporations state taxable income? Depreciation for...
-
What does the phrase theory of the case mean? Why is it important to develop a theory of the case in advance of trial?
-
Identify the two ways that trial material may be organized. What are the advantages and disadvantages of each method?
-
What tasks must be performed if a party files an appeal?
-
A genetic experiment involving peas yielded one sample of offspring consisting of 423423 green peas and 141141 yellow peas. Use a 0.050.05 significance level to test the claim that under the same...
-
Compare and contrast licensing and subcontracting.
-
Separation of Duties. Aurello Pellegrini, Dottore Commercialista (CONSOB), is approached by his client who has just reorganized his medium-sized manufacturing company to make it more structured by...
-
Proper Documentation. Properly designed and utilized forms facilitate adherence to prescribed internal control structure policies and procedures. One such form might be a multicopy purchase order,...
-
Separation of Duties. The division of the following duties is meant to provide the best possible controls for the Ma Foi Magasin, a small wholesale store in Dijon, France. 1 V Assemble supporting...
Study smarter with the SolutionInn App