5. The cost of retained earnings Aa Aa The cost of raising capital through retai

Question

5. The cost of retained earnings Aa Aa The cost of raising capital through retained earnings is less than 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 (rRF) 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 9.19% 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 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, Kennedy's cost of internal equity is: O 18.84% O 14.32% 15.07% O 16.58%

Explanation / Answer

Answer) The cost of equity through retained earning is less than cost of equity of newly issued stock it is because the cost of equity of newly issued stock is higher because of the flotation cost

Answer) Cost of equity by CAPM = Rf + Beta * Risk premium

= 3.86% + 0.78*5.75% = 0.08345 or 8.345%

Answer) Cost of equity = Bond yield + risk premium = 11.52% + 3.55% = 15.07%

Answer)

Current price of stock = Expected Dividend / (R-g)

45.56 = 1.38 / (r - 0.0727)

r = 0.103 or 10.30%

Answer) Sustainable growth rate = (1-dividend payout) X ROE

= (1-0.70) x 8 = 2.4

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