If a firm cannot invest retained earnings to earn a rate of return greater than or equal to the required rate of return on retained earnings, it
should return those funds to its stockholders.
The cost of equity using the CAPM approach
The current risk-free rate of return ($r_f$) is 3.86%, while the market risk premium is 6.17%. The Allen Company has a beta of 0.78. Using the Capital
Asset Pricing Model (CAPM) approach, Allen's cost of equity is
The cost of equity using the bond yield plus risk premium approach
The Kennedy 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. Kennedy's bonds yield 11.52%, and the firm's analysts estimate that the firm's risk premium on its stock over its bonds is
3.55%. Based on the bond-yield-plus-risk-premium approach, Kennedy's cost of internal equity is:
$\circ$ 15.07%
$\circ$ 18.08%
$\circ$ 16.58%
$\circ$ 18.84%
The cost of equity using the discounted cashflow (or dividend growth) approach
Johnson Enterprises's stock is currently selling for $45.56 per share, and the firm expects its per-share dividend to be $2.35 in one year. Analysts
project the firm's growth rate to be constant at 7.27%. Using the cost of equity using the discounted cashflow (or dividend growth) approach, what is
Johnson's cost of internal equity?
$\circ$ 16.78%
$\circ$ 12.43%
$\circ$ 15.54%
$\circ$ 13.05%
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:
$\bullet$ Carry forward a historical realized growth rate, and apply it to the future.
$\bullet$ Locate and apply an expected future growth rate prepared and published by security analysts.
$\bullet$ Use the retention growth model.
Suppose Johnson is currently distributing 55.00 of its earnings in the form of cash dividends. It has also historically generated an average return on
equity (ROE) of 8.00. Johnson's estimated growth rate is
