Question

4. The cost of retained earnings

If a firm cannot invest retained earnings to earn a rate of return   the required rate of return on retained earnings, it should return those funds to its stockholders.

The cost of equity using the CAPM approach

The current risk-free rate of return (rRFrRF) is 4.67% while the market risk premium is 5.75%. The Burris Company has a beta of 1.56. Using the capital asset pricing model (CAPM) approach, Burris’s cost of equity is     .

The cost of equity using the bond yield plus risk premium approach

The Adams 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. Adams’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, Adams’s cost of internal equity is:

17.79%

20.21%

19.40%

16.17%

The cost of equity using the discounted cash flow (or dividend growth) approach

Tucker Enterprises’s stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts project the firm’s growth rate to be constant at 5.72%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Tucker’s cost of internal equity?

10.88%

14.69%

13.60%

11.42%

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 Tucker 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 18%. Tucker’s estimated growth rate is   %.

Answer 1

1. Cost of equity using CAPM model=risk free rate+(beta*market risk premium)=4.67%+(1.56*5.75%)=13.64%

2. Adam's cost of equity using bond-yield-plus-risk-premium approach=bond yield+stock premium=10.28%+5.89%=16.17% (Option d is correct)

3. Tucker's cost of equity is discounted cash flow approach=(Dividend1/Share price)+growth rate=(2.35/45.56)+5.72%=5.16%+5.72%=10.88% (Option a is correct)

4. Growth rate=retention ratio*Return on equity

retention rate=(1-dividend payout ratio)=1-75%=25%

growth rate=25%*18%

=4.50%