Question

1.) The cost of raising capital through retained earnings is __________ (greater than, less than) the cost of raising capital through issuing new common stock.

2.) The current risk-free rate of return is 3.80% and the current market risk premium is 6.10%. Blue Hamster Manufacturing Inc. has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, Blue Hamster’s cost of equity is __________ (13.99%, 17,32%, 14.65%, 13.32%)

3.) Fuzzy Button Clothing Company is closely held and, as a result, cannot generate reliable inputs for the CAPM approach. Fuzzy Button’s bonds yield 11.50%, and the firm’s analysts estimate that the firm’s risk premium on its stock relative to its bonds is 3.50%. Using the bond-yield-plus-risk-premium approach, the firm’s cost of equity is __________ (15.00%, 18.75%, 16.50%, 14.25%)

4.) The stock of Cute Camel Woodcraft Company is currently selling for $32.45, and the firm expects its dividend to be $1.38 in one year. Analysts project the firm’s growth rate to be constant at 7.20%. Using the discounted cash flow (DCF) approach, Cute Camel’s cost of equity is estimated to be __________ (10.88%, 15.46%, 11.45%, 12.02%)

Answer 1

1)

Cost of raising capital through retained earnings less than the cost of raising capital through new common stock

Since issuing new common stock will have flotation cost

2)

Cost of equity = risk free rate + beta * market risk premium

= 3.8% + 1.56 * 6.1%

= 13.32%

3)

Cost of equity = bond yield + risk premium

= 11.5% + 3.5%

= 15.00%

4)

price = dividend next year/(Required return - growth rate)

=>

32.45 = 1.38/(cost of equity - growth rate)

=>

cost of equity = 1.38/32.45 + 0.072

= 11.45%