True or False: It is free for a company to raise money through retained earnings

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

Points:

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Explanation:

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 selector 1

13.99%

14.65%

13.32%

17.32%

.

Points:

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Explanation:

Fuzzy Button Clothing Company is closely held and, as a result, cannot generate reliable inputs for the CAPM approach. Fuzzy Button’s bonds yield 10.20%, 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 selector 1

13.01%

17.13%

13.70%

15.07%

.

Points:

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Explanation:

The stock of Cute Camel Woodcraft Company is currently selling for $25.67, 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...

16.98%

13.21%

12.58%

11.95%

.

Points:

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Explanation:

It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF approach. In general, there are three available methods to generate such an estimate:

Suppose Cute Camel Woodcraft Company is currently distributing 70.00% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 12.00%. Cute Camel Woodcraft Company’s estimated growth rate is...

11.70%

3.60%

12.30%

42.00%

.

• 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.

Explanation / Answer

Solution: 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.

The above statement is false. Shareholders have the right on the earnings of the firm. It is not “free “. It is the earnings of shareholders reinvested in the firm and shareholders expect a good return on it.

B) Blue Hamster’s Cost of equity

CAPM , Cost of equity, Ke= rf + ( rm - rf ) where rf is risk free rate, rm is market rate of return,

                                                          ( rm - rf ) is risk premium

= 3.80 + 1.56 * 6.10

=13.32

C) Fuzzy Button’s Cost of equity using Bond yield plus premium approach

Cost of equity = long term bond yield + risk premium

= 10.20+ 3.50

= 13.70

D) Cute Camel’s cost of equity using the DCF method

Current stock value = 25.67

Expected dividend = 1.38

Stable growth rate, g = 7.20

Value per share of stock = DPS/ Ke – g, Expected divided / Cost of equity – growth rate in dividends

Thus, 25 = 1.38/ (Ke – 7.20)

= 7.20 + 5.375

=12.58

E) Cute Camel Woodcraft’s estimated growth rate

Dividend payout ratio = 70 % hence retention ratio = 30 %

Return on equity = 12 %

Estimated growth rate = retention ratio * return on equity

=0 .30 * 0.12

= 36 %

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