Question

4. The cost of retained earnings

The cost of raising capital through retained earnings is   the cost of raising capital through issuing new common stock.

The cost of equity using the CAPM approach

The current risk-free rate of return (rRFrRF) is 3.86% while the market risk premium is 6.17%. The Burris Company has a beta of 0.92. 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 Taylor 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. Taylor’s bonds yield 11.52%, and the firm’s analysts estimate that the firm’s risk premium on its stock over its bonds is 4.95%. Based on the bond-yield-plus-risk-premium approach, Taylor’s cost of internal equity is:

16.47%

19.76%

18.12%

15.65%

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

Grant Enterprises’s stock is currently selling for $32.45 per share, and the firm expects its per-share dividend to be $1.38 in one year. Analysts project the firm’s growth rate to be constant at 7.27%. Estimating the cost of equity using the discounted cash flow (or dividend growth) approach, what is Grant’s cost of internal equity?

12.10%

10.94%

11.52%

14.40%

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 Grant is currently distributing 40% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 16%. Grant’s estimated growth rate is   %.

Answer 1

Sol: The values provided in the question to calculate the cost of equity using CAPM approach are as follows:

Risk free rate of return = 3.86%

Market risk premium = 6.17%

Burris Company beta = 0.92

The formula to calculate the cost of equity using CAPM approach is as follows:

Cost of equity = Risk free rate of return + (Beta * Market risk premium)

Using the values provided in the question,

Cost of equity = 3.86% + (0.92 * 6.17%)

= 3.86% + 5.6764%

= 9.5364%

= 9.54% (rounded to 2 decimals)

The values provided in the question to calculate the cost of equity using bond yield plus risk premium approach are as follows:

Taylor's bond yield = 11.52%

Firm's risk premium on its stock over its bonds = 4.95%

The formula to calculate the cost of equity using bond yield plus risk premium approach is as follows:

Cost of equity = Bond yield + Risk premium on equity

Using the values provided in the question,

Cost of equity = 11.52% + 4.95%

= 16.47%

The values provided in the question to calculate the cost of equity using discounted cash flow (or dividend growth) approach are as follows:

Grant's current stock price per share = $32.45

Per-share dividend in one year = $1.38

Firm's constant growth rate = 7.27%

The formula to calculate the cost of equity using discounted cash flow (or dividend growth) approach is as follows:

Cost of equity = (Per-share dividend in one year / Current stock price per share) + Constant growth rate

Using the values provided in the question,

Cost of equity = ($1.38 / $32.45) + 7.27%

= 0.0425 + 7.27%

= 4.25% + 7.27%

= 11.52% (rounded to 2 decimals)

The values provided in the question to calculate Grant's estimated growth rate are as follows:

%Distribution of earnings in the form of dividends = 40%

Average return on equity = 16%

The formula to calculate the estimated growth rate is as follows:

Estimated growth rate = Return on equity * (1 - %distribution of earning as dividends)

Using the values provided in the question,

Estimated growth rate = 16% * (1 - 0.4)

= 16% * 0.6

= 9.6%