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Homework answers / question archive / The cost of raising capital through retained earnings is the cost of raising capital through issuing new common stock
The cost of raising capital through retained earnings is the cost of raising capital through issuing new common stock. The cost of equity using the CAPM approach The current risk-free rate of return (IRF) is 3.86% while the market risk premium is 5.75%. The Allen Company has a beta of 0.78. Using the capital asset pricing model (CAPM) approach, Allen's cost of equity is The cost of equity using the bond yield plus risk premium approach The Kennedy Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company's cost of internal equity. Kennedy's bonds yield 10.28%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 3.55%. Based on the bond-yield-plus-risk-premium approach, Kennedy's cost of internal equity is: O 15.21% 13.83% 16.60% 17.29%
The cost of equity using the discounted cash flow (or dividend growth) approach Pierce Enterprises's stock is currently selling for $32.45 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firm's growth rate to be constant at 7.27%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Pierce's cost of internal equity? O 14.40% O 11.52% O 15.55% O 12.10% 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 DG 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 Pierce is currently distributing 75% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 12%. Pierce's estimated growth rate is %.
1. The cost of raising capital through retained earnings is Less Than the cost of raising capital through the issue of new common stocks. Let us understand from an example:
Suppose a company wants to start a new project, and is planning to finance partially by new issue as well as the cost of retained earnings:
Issue price: IP= 190; Current market price: CMP = 200; floatation cost: f = 5; expected dividend: D1 = 10 and Growth rate: g = 5%
Calculate the cost of equity and the cost of retained earnings?
Cost of retained earning = (D1 / CMP) + g
Cost of retained earning = (10 / 200) + 0.05 = 10 %
Cost of equity = (D1 / IP - f) + g
cost of equity = (10 / 190 - 5) + 0.05 = 10.41%
Thus, the cost of retained earning is less than the cost of equity i.e., new issue.
2. Calculation of cost of equity - Ke using:
The CAPM Approach
Formula; Ke = Rf + Beta ( Rm - Rf)
Rf = Risk free rate of return = 3.86% or 0.0386
Beta = 0.78
Market risk premium = (Rm - Rf) = 5.75% or 0.0575
The market risk premium is the difference between the expected return on a market portfolio and the risk-free rate.
Rm = Expected market rate of return
Ke = 0.0386 + 0.78 x 0.0575
Ke = 0.0386 + 0.0449
Ke = 8.35 %
3. Calculation of cost of equity using bond yield plus risk premium approach:
Bond Yield Plus Risk Premium Equation states that the required return on equity equals the yield of the company's long-term debt plus the equity's risk premium:
Ke = Bond yield + equity's risk premium
Bond yield = 10.28 %
Equity's risk premium = 3.55 %
Ke = 10.28 + 3.55 = 13.83 %
4. Calculation of cost of equity using the discounted cash flow (or dividend growth) approach:
According to the dividend discount model, the intrinsic value of a share of stock is the present value of the share’s expected future dividends. Based on Gordon’s constant growth model, dividends are expected to grow at a constant rate, g. Therefore, assuming that the share price reflects the intrinsic value, the value of a stock is:
Ke = (D1 / P0) + g
Where:
P0 = the current share price = 32.45
D1 = the dividend to be paid in the next period = 1.38
Ke = the cost of equity = 11.52 %
g = the growth rate = 7.27 % or 0.0727
Ke = (1.38 / 32.45) + 0.0727
Ke = 0.0425 + 0.0727 = 0.1152 or 11.52 %
5. Calculation of estimated growth rate:
The growth rate can be calculated by multiplying a company’s earnings retention rate by its return on equity. The growth rate can be calculated on a historical basis and averaged in order to determine the company’s average growth rate since its inception.
The growth rate is calculated by multiplying the company’s earnings retention rate by its return on equity. The formula to calculate the growth rate is:
g = Br x ROE
g = Growth rate =
Br = Retention rate = 1 - Dividend payout rate = 1 - 0.75 = 0.25 or 25 %
Dividend payout rate = 75 % or 0.75
ROE = Return on equity = 12 % 0.12
g = 0.25 x 0.12
g = 0.03 or 3 %
