The cost of retained earnings 4. The cost of retained earnings Aa Aa True or Fal

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The cost of retained earnings

4. The cost of retained earnings Aa Aa True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. O False O True The cost of equity using the CAPM approach The current risk-free rate of return (rRF) is 4.23%, while the market risk premium is 5.75%. the Jefferson Company has a beta of 0.78. Using the Capital Asset Pricing Model (CAPM) approach, Jefferson's cost of equity is The cost of equity using the bond yield plus risk premium approach The Hoover 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. Hoover's bonds yield 11.52%, 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, Hoover's cost of internal equity is: O 14.3296 15.07% O 18.08% O 16.5890 The cost of equity using the discounted cashflow (or dividend growth) approach Johnson Enterprises's stock is currently seling be $1.38 in one year. Analysts profect the hrn's grovth rate to s per share, and the firm expects its per-share dividend to m growth rate to be constant at 7.27%. Using the cost of equit

Explanation / Answer

A. False. Since the Retained Earnings are part of the shareholder's equity, the expected return on these is the cost of Equity.

B. CAPM: Re = Rf + Beta * Market Risk Premium,
Here, Rf = 4.23%, Beta = 0.78, Market Risk Premium = 5.75%

Re = 0.0423 + 0.78*0.0575 = 8.715%

C. Cost of Equity = Bond Yield + Risk Premium = 11.52% + 3.55% = 15.07%

D. For Dividend Discount Model,
Cost of Equity, Re = D1/P0 + g
D1(Dividend Next Year) = 1.38, P0(Current Share Price) = 32.45, g(Growth Rate) = 7.27%
Hence, Re = 1.38/32.45 + 0.0727 = 11.52%

E. Growth Rate = ROE x Retention Ratio = 0.14 x (1 - 0.70) = 0.14 x 0.30 = 4.2%

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