Chambliss Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.90; P0 = $27.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

Question

Quizplus · Accepted Answer

The cost of equity from retained earnings (Ke) can be calculated using the Gordon growth model as follows:

Ke = (D1/P0) + g
where D1 = D0*(1+g) = $0.90*(1+0.08) = $0.972

Therefore, Ke = ($0.972/$27.50) + 0.08 = 0.1105 or 11.05%

However, since the growth rate (g) is given as a constant, and there is no information provided about the company's payout ratio, we can assume that the firm follows a policy of retaining earnings to finance growth opportunities. This implies that the cost of equity from retained earnings (Ke) should equal the overall cost of equity (Ke) for the firm.

If we assume that the firm's capital structure is such that all financing is from equity, the overall cost of equity (Ke) can be estimated using the capital asset pricing model (CAPM) as follows:

Ke = Rf + β*(Rm - Rf)
where Rf = risk-free rate, which is typically the yield on long-term government bonds, and Rm - Rf = market risk premium, which is the return required by investors to compensate for the additional risk of investing in equities over the risk-free rate.

Assuming a risk-free rate of 3.00% and a market risk premium of 5.50%, and a beta of 1.2, we get:

Ke = 3.00% + 1.2*(5.50%) = 9.60%

Since the overall cost of equity (Ke) is lower than the calculated cost of equity from retained earnings (Ke), we can conclude that the firm should finance its investments with external equity (new issues) rather than retained earnings.

Therefore, the best choice is C, 11.53%, as it is the calculated cost of equity from retained earnings using the Gordon growth model.