3. Cost of retained earnings
Cost of retained earnings (ks) is the return stockholders require on the company's common stock.

There are three methods one can use to derive the cost of retained earnings:
a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach

a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).

The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.

Formula 11.3

Example: CAPM approach
For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?

Answer:
ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%

b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):

Formula 11.4

ks= long-term bond yield + risk premium

Example: bond-yield-plus-premium approach
The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?

Answer:
ks = 7% + 4% = 11%

c) Discounted Cash Flow ApproachAlso known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.

Formula 11.5

ks = D1 + g;
       P0

where:
D1 = next year's dividend
g = firm's constant growth rate
P= price

Typically, you must also estimate g, which can be calculated as follows:

Formula 11.6

g = (retention rate)(ROE) = (1-payout rate)(ROE)

Example: discounted cash flow approach
Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach?

Answer:
g must first be calculated:
g = (1-0.3)(0.10) = 7.0%

ks = 2/40 + 0.07 = 0.12 or 12%

Exam Tips and Tricks
Of the three approaches to determine the cost of retained earnings, be most familiar with the CAPM approach and the dividend-yield-plus-growth approach


Cost of Newly Issued Stock

Related Articles
  1. Tech

    CAPM vs. Arbitrage Pricing Theory: How They Differ

    Both project the expected rate of return given the level of risk assumed, but they consider different variables.
  2. Investing

    Taking Shots At CAPM

    Find out why many investors think the capital asset pricing model is full of holes.
  3. Investing

    Treasury Shares Wreak Havoc On Retained Earnings

    Aeropostale's retirement of 47.5 million shares in October is worth looking into.
  4. Investing

    Should You Use DCF for Valuation?

    We explain the two primary valuation techniques—DCF and Comparables—used to predict future stock prices.
  5. Investing

    Is Apple's Stock Over Valued Or Undervalued?

    Despite several drawbacks, the CAPM gives an overview of the level of return that investors should expect for bearing only systematic risk. Applying Apple, we get annual expected return of about ...
  6. Investing

    PotashCorp Gives K+S Nothing New to Talk About

    PotashCorp (NYSE: POT) really needs to sweeten the pot if it wants to bring German rival K+S to the negotiating table. The merger target says PotashCorp's latest overture offers nothing new, ...
  7. Investing

    Introduction To International CAPM

    ICAPM is one of several models used to determine the required return on an asset, discover its limitations and how to use it.
  8. Investing

    How to Calculate Required Rate of Return

    The required rate of return is used by investors and corporations to evaluate investments. Find out how to calculate it.
  9. Investing

    4 Ways To Value A Real Estate Rental Property

    Real estate rentals can be a profitable alternative to the buy-and-sell approach if investors know how to make accurate valuations.
Frequently Asked Questions
  1. Who are Whole Foods' (WFM) main competitors?

    Learn more about Whole Foods Markets, who insists its products are sustainable. Thanks to the competition, however, its marketing ...
  2. What are the Differences Between Ex Works (EXW) and Free On Board (FOB)?

    Learn about Ex Works and Free on Board, the main difference between these Incoterms, and the responsibilities of buyers and ...
  3. What are Common Examples of Monopolistic Markets?

    Discover what causes real instances of market monopoly, how it persists and where monopoly privilege is most common in the ...
  4. What is the gold standard?

    The gold standard is a monetary system where a country's currency or paper money has a value directly linked to gold, but ...
Trading Center