Question

"explain how an increase in the risk‐free interest rate affects share prices, the 181 6. What determines whether an increase in the share of retained earnings increases equity premium, and the rate of return on internal investment"

Answer 1

An increase in the risk-free interest rate negatively affects the share prices. According to CAPM, the required rate of return is given by

.

With the increase in the risk-free rate (rf) the required rate of return increases, which indicates an increase in the risk in the equity segment and hence a negative impact on the share prices.

For a given Net income if the dividends paid decreases then retained earnings increase. Dividend income is one of the return components for an equity investor and a decrease in dividend results in a lower return on investment. To make up for the decrease in return on investment, the equity investors seek higher equity premium. So, dividends paid determines whether an increase in the share of retained earnings increases equity premium.