5. The cost of retained earnings

The cost of retained earnings

True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders.

False

True

The cost of equity using the CAPM approach

The yield on a three-month T-bill is 3%, the yield on a 10-year T-bond is 3.45%. The market risk premium is 6.57% and the Allen Company has a beta of 0.75. Using the Capital Asset Pricing Model (CAPM) approach, Allens cost of equity is .

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

In contrast, the Hoover Company is closely held and, therefore, cannot generate reliable inputs with which to apply the CAPM method to estimate its cost of internal equity (retained earnings). However, its management knows that its outstanding bonds are currently yielding 7.94%, and the firms analysts estimate that the risk premium of its stocks over its bonds is currently 1.39%. As result, Hoovers cost of internal equity (rss)based on the own-bond-yield-plus-judgemental-risk-premium approachis:

8.86%

9.33%

11.20%

10.26%

The cost of equity using the discounted cash flow (or dividend-yield-plus-growth-rate) approach

Ford Enterprisess stock is currently selling for $19.25 per share, and the firm expects its per-share dividend to be $2.00 in one year. Analysts project the firms growth rate to be constant at 4.20%. Using the discounted cash flow (or dividend-yield-plus-growth-rate) approach, what is Fords cost of internal equity?

14.59%

12.40%

13.86%

15.32%

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 dividend-yield-plus-growth-rate) 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 Ford Enterprisess is currently distributing 55% of its earnings as cash dividends. It has also historically generated an average return on equity (ROE) of 10.50%. It is reasonable to estimate Fords growth rate is .