Blanks & Answer Choices
(1) - Lower , Identical, Higher
(2) - Externality, Oppurtunity, Confiscatory
(3) - Well, Somewhat, Not Well
(4) - Well, Somewhat, Not Well
(5) - Growth, Beta, Yield
(6) - Understate, Overstate, Approximate
(7) - Identical to, Different from
(8) - Recession, Equalibrium, Upturn
(9) - CAPM cost of equity %
(10) - Bond yield plus risk premium %
(11) - DCF cost of equity %
(12) - The best eatimate is the highest perecentage of all three approches, The best estimate is the average of the three approaches, The best estimate is the lowest percentage of the three approaches
4. 4: 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 an) Select cost, re, than equity raised from retained earnings. I 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 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: TRE + (RPM) + (ne) The CAPM estimate ofr, is equal to the risk-free rate, plus a risk premium that is equal to the risk premium on an average stock, (R), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, b. 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 the correct value of a Bond Yield Plus Risk Premium 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: - Bond yield. Risk premium. Note that this risk premium is select v 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 DCF approach for estimated the cost of retained earnings, is given as follows: T. +- D/P, +Expected a investors expect to receive a dividend yield, P. plus a capital gain, g, for a total expected return. In select v. this expected return is also equal to the required return. It's The DCF approach for estimated the cost of retained earnings, is given as follows: T. -1,- DJP + Expected Investors expect to receive a dividend yield, P. plus a capital gain, for a total expected retum. In Sect . this expected return is also equal to the required return. It's easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity. Also, it is difficult to determine the proper growth especially if past growth rates are not expected to continue in the future. However, we can use growth rates as projected by security analysts, who regularly forecast growth rates of earnings and dividends. Which method should be used to estimate ? If management has confidence in one method, it would probably use that method's estimate. Otherwise, it might use some weighted average of the three methods. Judgment is important and comes into play here, as is true for most decisions in finance Quantitative Problem: Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, Di, to be $1.80 and it expects dividends to grow at a constant rate g - 5.6%. The firm's current common stock price, Pois $25.00. The current risk-free rate, f. 4,5%; the market risk premium, RP.-5.8%, and the firm's stock has a current beta, b, - 1.15. Assume that the firm's cost of debt, to is 11.63%. The firm uses a 2.8% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to two decimal places. CAPM cost of equity 9% Bond yield plus risk premium DCF cost of equity % What is your best estimate of the firm's cost of equity? 5. 5: The Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced to it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows Cost of equity from new stock = r. - wn+* The difference between the notation-wajuired cost of equity and the cost of equity calculated without the rotation adjustment represents the rotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D. to be $2.50 and it expects dividends to grow at a constant rate 9 - 5%. The nrm's current common stock price, Po, is $20.00. it needs to issue new common stock, the firm will encounter a 5.5% Potation cost, F. What is the Rotation cost adjustment that must be added to its con of retained earnings? Do not round intermediate calculations, Round your answer to two decimal places. what is the cost of new common equity considering the estimate made from the three estimation methodologies? Do not round intermediate calculations. Round your answer to two cimal places 4. 4: 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 an) Select cost, re, than equity raised from retained earnings. I 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 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: TRE + (RPM) + (ne) The CAPM estimate ofr, is equal to the risk-free rate, plus a risk premium that is equal to the risk premium on an average stock, (R), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, b. 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 the correct value of a Bond Yield Plus Risk Premium 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: - Bond yield. Risk premium. Note that this risk premium is select v 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 DCF approach for estimated the cost of retained earnings, is given as follows: T. +- D/P, +Expected a investors expect to receive a dividend yield, P. plus a capital gain, g, for a total expected return. In select v. this expected return is also equal to the required return. It's The DCF approach for estimated the cost of retained earnings, is given as follows: T. -1,- DJP + Expected Investors expect to receive a dividend yield, P. plus a capital gain, for a total expected retum. In Sect . this expected return is also equal to the required return. It's easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity. Also, it is difficult to determine the proper growth especially if past growth rates are not expected to continue in the future. However, we can use growth rates as projected by security analysts, who regularly forecast growth rates of earnings and dividends. Which method should be used to estimate ? If management has confidence in one method, it would probably use that method's estimate. Otherwise, it might use some weighted average of the three methods. Judgment is important and comes into play here, as is true for most decisions in finance Quantitative Problem: Barton Industries estimates its cost of common equity by using three approaches: the CAPM, the bond-yield-plus-risk-premium approach, and the DCF model. Barton expects next year's annual dividend, Di, to be $1.80 and it expects dividends to grow at a constant rate g - 5.6%. The firm's current common stock price, Pois $25.00. The current risk-free rate, f. 4,5%; the market risk premium, RP.-5.8%, and the firm's stock has a current beta, b, - 1.15. Assume that the firm's cost of debt, to is 11.63%. The firm uses a 2.8% risk premium when arriving at a ballpark estimate of its cost of equity using the bond-yield-plus-risk-premium approach. What is the firm's cost of equity using each of these three approaches? Round your answers to two decimal places. CAPM cost of equity 9% Bond yield plus risk premium DCF cost of equity % What is your best estimate of the firm's cost of equity? 5. 5: The Cost of Capital: Cost of New Common Stock If a firm plans to issue new stock, flotation costs (investment bankers' fees) should not be ignored. There are two approaches to use to account for flotation costs. The first approach is to add the sum of flotation costs for the debt preferred, and common stock and add them to the initial investment cost. Because the investment cost is increased, the project's expected rate of return is reduced to it may not meet the firm's hurdle rate for acceptance of the project. The second approach involves adjusting the cost of common equity as follows Cost of equity from new stock = r. - wn+* The difference between the notation-wajuired cost of equity and the cost of equity calculated without the rotation adjustment represents the rotation cost adjustment. Quantitative Problem: Barton Industries expects next year's annual dividend, D. to be $2.50 and it expects dividends to grow at a constant rate 9 - 5%. The nrm's current common stock price, Po, is $20.00. it needs to issue new common stock, the firm will encounter a 5.5% Potation cost, F. What is the Rotation cost adjustment that must be added to its con of retained earnings? Do not round intermediate calculations, Round your answer to two decimal places. what is the cost of new common equity considering the estimate made from the three estimation methodologies? Do not round intermediate calculations. Round your answer to two cimal places
