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

    Evaluating Retained Earnings: What Gets Kept Counts

    A company's retained earnings matter. Be investment-savvy and learn how to analyze this often overlooked information.
  2. Investing

    Taking Shots At CAPM

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

    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.
  4. Investing

    The Capital Asset Pricing Model: an Overview

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

    Treasury Shares Wreak Havoc On Retained Earnings

    Aeropostale's retirement of 47.5 million shares in October is worth looking into.
  6. 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 ...
  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

    Reduce Your Risk With ICAPM

    Avoid unnecesary risks involved in CAPM calculations by also incorporating ICAPM into the mix.
  9. Investing

    Microsoft Is Paying Dividends. Is Its Share Price Undervalued Or Overvalued Based On DDM? (MSFT)

    How can you use the dividend discount model to estimate the value the common stock of Microsoft?
Frequently Asked Questions
  1. What's considered to be a good debt-to-income (DTI) ratio?

    Your debt-to-income ratio helps lenders determine your credit worthiness. Find out how to calculate your score and how to ...
  2. What is the difference between a loan and a line of credit?

    Learn to differentiate between lines of credit and standard loans, and determine when you are likely to use each method of ...
  3. What does a Chief Financial Officer (CFO) do?

    A CFO is responsible for accurate reporting of a company's financial information, investing the company's money and identifying ...
  4. How did George Soros break the Bank of England?

    George Soros pocketed $1 billion by betting against the British pound, cementing his reputation as the premier currency speculator ...
Trading Center