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: