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. Investing

    The Capital Asset Pricing (CAPM) Model: Pros and Cons

    CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations.
  2. Investing

    Capital Asset Pricing Model - CAPM

    CAPM is a model that describes the relationship between risk and expected return.
  3. Investing

    Taking Shots At CAPM

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

    The Capital Asset Pricing Model: An Overview

    CAPM helps you determine what return you deserve for putting your money at risk.
  5. Trading

    Valuation Models: Apple’s Stock Analysis With CAPM

    The capital asset pricing model, or the CAPM, estimates the expected return of an asset based on the systematic risk of the asset’s return.
  6. Markets

    Is This Why PotashCorp Really Wants to Buy K+S?

    The $8.7 billion takeover bid by PotashCorp (NYSE: POT) for German rival K+S may not just be an effort to use the depressed pricing environment to consolidate the weakened rivals in the industry ...
  7. Investing

    Should You Use DCF for Valuation?

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

    DCF Analysis: Calculating The Discount Rate

    By Ben McClure Contact Ben Having projected the company's free cash flow for the next five years, we want to figure out what these cash flows are worth today. That means coming up with an appropriate ...
  9. Investing

    The Equity-Risk Premium: More Risk For Higher Returns

    Learn how the expected extra return on stocks is measured and why academic studies usually estimate a low premium.
  10. 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 ...
Trading Center