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) _____ cost, r_e, than equity raised from retained earnings, r_s, due to flotation costs required to sell new common stock.

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.

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The firm's cost of retained earnings can be estimated using the following equation:

r_s = r_RF + (RP_M)b_i = r_RF + (r_M - r_RF)b_i r_RF is equal to the risk-free rate, plus a risk premium that is equal to the risk premium on an average stock, (r_M - r_RF), scaled up or down to reflect the particular stock's ________ as measured by its beta coefficient, b_i.

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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: r_s = Bond yield + Risk premium. Note that this risk premium is different from the risk premium given in the CAPM. This method doesn't produce a precise cost of equity, but does provide a ballpark estimate.

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We can estimate the cost of retained earnings, r_s as follows: r s = r ^ _s = D₁/P₀ + Expected g_L Investors expect to receive a dividend yield, D 1 / P 0, plus a capital gain, g_L, for a total expected 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.

Choices:

higher lower equal

CAPM DCF BondYieldPlusRiskPremium Retention model

risk growth investment

BondYieldPlusRiskPremium DCF CAPM

DCF BondYieldPlusRiskPremium CAPM