Question

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. True False The cost of equity using the CAPM approach The current risk-free rate of return (TRF) is 4.67%, while the market risk premium is 6.17%. the Jefferson Company has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, Jefferson's cost of equity is The cost of equity using the bond yield plus risk premium approach The Harrison 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. Harrison's bonds yield 11.52%, 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, Harrison's cost of internal equity is: O O O O 17.41% 21.76% 16.54% 19.15%

Answer 1

FALSE, Retained earnings are not free

They come with Opportunity cost as the money would have been somewhere profitable has not been retained

Cost of Equity as per CAPM = Risk free rate + beta*Market risk premium

= 4.67% + 1.56*6.17%

= 14.2952%

i.e. 14.30%

Cost of Equity = Bond yield + Risk premium

= 11.52% + 5.89%

= 17.41%

Stock Price = Expected Dividend/(Cost of Equity – growth rate)

45.56 = 1.38/(Cost of Equity – 7.27%)

Cost of Equity = 10.30%

Growth rate = ROE*(1-Payout ratio)

= 20%*(1-45%)

= 11%