4. The cost of retained earnings

The cost of raising capital through retained earnings is the cost of raising capital through issuing new common stock.

The cost of equity using the CAPM approach

The current risk-free rate of return (rRFrRF) is 3.86% while the market risk premium is 5.75%. The Jefferson Company has a beta of 1.56. Using the capital asset pricing model (CAPM) approach, Jeffersons cost of equity is .

The cost of equity using the bond yield plus risk premium approach

The Kennedy Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a companys cost of internal equity. Kennedys bonds yield 11.52%, and the firms analysts estimate that the firms risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Kennedys cost of internal equity is:

17.41%

20.89%

16.54%

21.76%

The cost of equity using the discounted cash flow (or dividend growth) approach

Pierce Enterprisess stock is currently selling for $25.67 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firms growth rate to be constant at 7.27%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Pierces cost of internal equity?

15.81%

17.08%

12.02%

12.65%

Estimating growth rates

It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF or DG approach. In general, there are three available methods to generate such an estimate:

	Carry forward a historical realized growth rate, and apply it to the future.
	Locate and apply an expected future growth rate prepared and published by security analysts.
	Use the retention growth model.

Suppose Pierce is currently distributing 70% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 20%. Pierces estimated growth rate is %.