DEF plc. is a leading producer of mountain sports equipment. The company is currently evaluating a new product: self-heating hiking boots. The CEO and her team have already estimated the projects cash flows and the initial cost required for the project is 5,000,000. The company will finance the project by issuing corporate bonds worth of 1,500,000, issuing preferred stock worth of 500,000 and the remaining 3,000,000 will be financed from retained earnings. Also note that:

(1) DEF has recently issued a 15-year, 6% coupon corporate bond, that pays coupon twice per year. The bond face value is 1,000 and the price is 954.

(2) The firm uses short-term debt of 200,000 to finance working capital requirements.

(3) The companys preferred stock is traded at 4.50, pays 30% of 1 par as annual dividend, twice per year. In case DEF issues new preferred stock, issuance costs will be 5%.

(4) Government bonds currently offer 2%, and the market risk premium is estimated at 6%. The firms beta is 1.3.

(5) DEF last dividend (D0) to common shareholders was 0.35, having steadily increased from 0.28 four years ago. DEFs current common stock price is 11.

(6) DEFs tax rate is 20 percent.

a. Describe the theoretical rationale behind the cost of retained earnings.

b. Calculate DEFs cost of retained earnings using the CAPM approach. Should you use long-term or short-term government bonds as the best estimate of the risk- free rate? Explain.