4. The cost of retained earnings True or False: It is free for a company to rais
ID: 2801849 • Letter: 4
Question
4. The cost of retained earnings 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 True O False The cost of equity using the CAPM approach The current risk-free rate of return (er) is 4.23%, while the market risk premium is 6.63%, the Allen Company has a beta of 1.56. 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 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 10.28%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 5.89. Based on the bond-yield-plus-risk-premium approach, Hoover's cost of internal equity is: O 19.40% 15.36% O 16.1796 O 17.79%Explanation / Answer
a.
Retained earnings are part of net income that company retain after paying some of of net income as dividend. So,
It is free for a company to raise money through retained earnings, because retained earnings represent money that is left after dividend are paid out to its shareholder.
Statement is true.
b.
Cost of equity for Allen Company is calculated below using CAPM formula:
Cost of equity = Risk free rate + (Risk Premium × Beta)
= 4.23% + (6.63% × 1.56)
= 4.23% + 10.34%
= 14.57%
Cost of common Equity is 14.57%.
c.
Cost of equity using bond yield plus risk premium is calculated below:
Cost of equity = Bond yield + Risk Premium
= 10.28% + 5.89%
= 16.17%
Cost of equity using bond yield plus risk premium is 16.17%.
Option (D) is correct answer.
d.
Cost of equity using dividend discount model is calculated below:
Cost of equity = (Expected dividend / Current stock price) + Growth rate
= ($2.35 / $32.45) + 5.72%
= 7.24% + 5.72%
= 12.96%
Cost of equity using dividend discount model is 12.96%.
Option (C) is correct answer.
e.
Payout ratio = 70%
Retention ratio = 30%
Return on equity = 10%.
Growth rate = Retention ratio × Return on equity
= 30% × 10%
= 3%
Growth rate of ford stock is 3%.
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