The cost of raising capital through retained earnings is the cost of raising cap

Question

The cost of raising capital through retained earnings is the cost of raising capital through issuing new common stock. The current risk-free rate of return is 4.2%. The market risk premium is 6.1%. D'Amico Co. has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, D'Amico's cost of equity is. The cost of equity using the CAPM approach Kuhn Co. is closely held and, consequently, cannot generate reliable inputs for the CAPM approach. Kuhn's bonds yield 11.5%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is 3%. Using the bond-yield-plus-risk-premium approach, find the firm's cost of equity: 18.1% 17.4% 13.8% 14.5% The cost of equity using the Discounted Cash flow (or Dividend Growth) Approach Turnbull Co.'s stock 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 5.7%. Using the discounted cash flow (DCF) approach, what is Turnbull's cost of equity? 9.5% 10.0% 12.5% 13.5%

Explanation / Answer

Part 1)

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

It is so because the cost of issuing new common stock would involve flotation cost which is not applicable in the case of retained earnings.

__________

Part 2)

The cost of equity with the use of CAPM is calculated as follows:

Cost of Equity = Risk Free Rate + Beta*(Market Risk Premium)

Using the values provided in the question, we get,

D' Amico's Cost of Equity = 4.2% + 1.56*6.1% = 13.716% or 13.72%

__________

Part 3)

The cost of equity with the use of bond-yield-plus-risk-premium approach can be calculated as follows:

Cost of Equity = Bond Yield + Risk Premium

Using the values provided in the question, we get,

Kuhn's Cost of Equity = 11.5% + 3% = 14.5% (which is Option D)

__________

Part 4)

The cost of equity with the use of discounted cash flow approach can be calculated as follows:

Cost of Equity = D1/Current Stock Price + Growth Rate where D1 is the Dividend Next Year

Using the values provided in the question, we get,

Turnbull's Cost of Equity = 1.38/(32.45) + 5.7% = 10% (which is Option B)

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