. 4:The Cost of Capital: Cost of Retained Earnings The Cost of Capital: Cost of
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. 4:The Cost of Capital: Cost of Retained Earnings The Cost of Capital: Cost of Retained Earnings 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 cument year's earnings and (2) by issuing new common stock. Equity raised by issuing stock has a n Select- cost e than equity raised fro etained earnings s due to flotation costs equired to sel new com mon stock. So e argue that retained earings should be free because they e resent m oney that is left o er after dividends are paid. While it is true that no direct costs are associated with retained earnings, his capital still has a cost, a n -Select # cost. The firm's after-tax carnings belong to its stockholders, and these earnings serve to compensate them for the use of ther capital. The carnings can either be paid out in the form of dividends to stockholders who could have invested this money in alternative investments or retained for reivestment in the firm. Therefore, the firm needs to earn at least as much on any carnings retained as the stockholders could earn on alternative investments of comparable risk. If the firm cannot invest retained carnings to earn at least rs, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return. There are three procedures thet can be used to estimate the cost of retained carnings: the Capital Asset Pricing Madel (CAPM), the Band-Yield-Plus-Risk-Premium approach, and the Discounted Cash Flow (DCF) epproach. CAPM The firm's cost of retained carnings can be estimated using the CAPM equation as follows: The CAPM estimate of rs is equal to the risk-free rate, FRF. plus a risk premium that is equal to the risk premium on an average stock, (rM-FRF), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, bi- This model assumes that a firm's stockholders are select diversified, but if they are -Select t diversified, then the firm's true investment risk ould not be measured by Select-t and the APM estimate would Select the correct value of rs Band Yieid Plus Risk Premium tf reliable inputs for the CAPM are not avalable 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 firms stock over its own bonds generaly ranges from 3 to 5 percentage points. The equation is s n as s-Bond yield + Risk premium. Note that this risk premium is se ect the risk premium given in the CAPM. This method doesn't produce a precise cost of equity, but does provide a ballpark estimate. OCF The DCF approach for estimated the cost of retained earnings, rs. is given as follows: t.-t,= +Expected g Investors expect to receive a dvidend yield,, plus a capital gain, g, for total expected return. In Select varies from day to day, which leads to fluctuations in the DCF cost of equity. Also, it is difficult to determine the proper growth especially if past growth rates are not expected to continue in the future. However, we can use growth rates as projected by security analysts, who reçularly forecast growth rates of earnings and dividends this expected return is also cqual to the required return. It's casy to calculate the dividend yield; but because stock prices fluctuate, the yield Which method should be used to estimate rs? If management has confidence in one method, it would probably use that method's estimate. Otherwise, it might use some weighted average of the three methods. Judgment is important and comes into play here, as is true for most decisions in financeExplanation / Answer
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1 Higher 2 Opportunity 3 well 4 not well diversified 5 Beta 6 understate 7 Different from 8 equilibriumRelated Questions
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