Question

5. The cost of retained earnings Aa Aa 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 (rRE) is 3.86%, while the market risk premium is 6.63%. the D'Amico Company has a beta of 0.78. Using the Capital Asset Pricing Model (CAPM) approach, D'Amico's cost of equity is The cost of equity using the bond yield plus risk premium approach The Kennedy 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. Kennedy's bonds yield 10.28% , and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 3.55 %. Based on the bond-yield-plus-risk-premium approach, Kennedy's cost of internal equity is: O 13.14% O 16.60% O 13.83% 15.21% The cost of equity using the discounted cashflow (or dividend growth) approach Kirby Enterprises's stock is currently selling for $32.45 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 7.27 %. Using the cost of equity using the discounted cashflow (or dividend growth) approach, what is Kirby's cost of internal equity? O 19.59% O 15.24% O 13.78% O14.51%

Answer 1

Question 1:

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

Question 2:

Based on CAPM,

Expected return on stock = Risk free rate + Beta * Market risk premium

Expected return on stock = 3.86% + 0.78 * 6.63% = 9.03%

Question 3:

Based on Bond Yield plus risk premium approach

Cost of Equity = Bond Yield + Risk Premium

Cost of Equity = 10.28% + 3.55% = 13.83%

Question 4:

This question requires application of constant growth dividend discount model according to which: Div Po r-g Po Price of Stock Div Estimated Dividends for Next Period r = Required Rate of Return g= Growth Rate

$32.45 = \frac{2.35}{r - 0.0727}$

r - 0.0727 = 0.0724

r = 14.51%

Question 5:

Growth Rate = ROE * (1 - Dividend payout ratio)

Growth rate = 14% * (1 - 55%) = 6.30%