Candice My Home Courses Catalog and Study Tools Rental Options < < CENGAGE MINDTAP Ch 10- Blueprint Problems - The Cost of Capital Back to Assignment Attempts Q Search this course Keep the Highest/12 4. The Cost of Capital: Cost of Retained Earnings College Success Tips Career Success Tips Help Give Feedback 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, r,, 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: rs = TRF + (RPM)b; = TRF + (TM - TRF)b The CAPM estimate of r, 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- the correct value of rs. Bond Yield Plus Risk Premium A-Z