The cost of retained earnings If a firm cannot invest retained earnings to earn

Question

The cost of retained earnings If a firm cannot invest retained earnings to earn a rate of return return on retained earnings, it should return those funds to its s the required rate of less than greater than or equal to The cost of equity using the CAPM approaclh The yield on a three-month T-bill is 4%, the yield on a 10-year T-bond is 4.94%, the market risk premium is 9.38%. and the Monroe Company has a beta of 1.03. Using the Capital Asset Pricing Model (CAPM) approach, Monroe's cost of equity is The cost of equity using the bond yield plus risk premium approach In contrast, the Harrison Company is closely held and, therefore, cannot generate reliable inputs with which to apply the CAPM method to estimate its cost of internal equity (retained earnings). However, its management knows that its outstanding bonds are currently yielding 11.34%, and the firm's analysts estimate that the risk premium of its stocks over its bonds is currently 1.90%. As result, Harrison's cost of internal equity (rs)-based on the own-bond-yield-plus-judgemental-risk-premium approach-is 13.24% 15.89% 16.55% 12.58% The cost of equity using the discounted cash flow (or dividend-yield-plus-growth-rate) approach O Type here to search Address

Explanation / Answer

1)

Greater than or equal to

retained earnings should be returne to shareholders if it cannoy reinvest at a greater rate of return

2)

cost of equity = risk free rate + beta ( market risk premium)

cost of equity = 0.0494 + 1.03 ( 0.0938)

cost of equity = 0.1460 or 14.60%

3)

Cost of equity = Bond yield + risk premium

Cost of equity = 11.34% + 1.90%

Cost of equity = 13.24%

4)

Cost of equity = ( D1 / stock price) + growth rate

Cost of equity = ( 2 / 22.25) + 0.062

Cost of equity = 0.1519 or 15.19%

5)

Growth rate = ( 1 - dividend payout ratio) * ROE

Growth rate = ( 1 - 0.65) * 0.08

Growth rate = 0.0280 or 2.80%

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