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True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders.

True

False

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Explanation:

The current risk-free rate of return is 3.80% and the current market risk premium is 6.10%. Blue Hamster Manufacturing Inc. has a beta of 1.56. Using the Capital Asset Pricing Model (CAPM) approach, Blue Hamster’s cost of equity is selector 1

13.99%

14.65%

13.32%

17.32%

.

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Explanation:

Fuzzy Button Clothing Company is closely held and, as a result, cannot generate reliable inputs for the CAPM approach. Fuzzy Button’s bonds yield 10.20%, and the firm’s analysts estimate that the firm’s risk premium on its stock relative to its bonds is 3.50%. Using the Bond-Yield-plus-Risk-Premium approach, the firm’s cost of equity is selector 1

13.01%

17.13%

13.70%

15.07%

.

Points:

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Explanation:

The stock of Cute Camel Woodcraft Company is currently selling for $25.67, and the firm expects its dividend to be $1.38 in one year. Analysts project the firm’s growth rate to be constant at 7.20%. Using the discounted cash flow (DCF) approach, Cute Camel’s cost of equity is estimated to be...

16.98%

13.21%

12.58%

11.95%

.

Points:

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Explanation:

It is often difficult to estimate the expected future dividend growth rate for use in estimating the cost of existing equity using the DCF approach. In general, there are three available methods to generate such an estimate:

• Carry forward a historical realized growth rate, and apply it to the future.
• Locate and apply an expected future growth rate prepared and published by security analysts.
• Use the retention growth model.

Suppose Cute Camel Woodcraft Company is currently distributing 70.00% of its earnings in the form of cash dividends. It has also historically generated an average return on equity (ROE) of 12.00%. Cute Camel Woodcraft Company’s estimated growth rate is...

11.70%

3.60%

12.30%

42.00%

.

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Casey Durgan
Casey DurganLv2
29 Sep 2019

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Related questions

Which of the following statements are true? Select 4 that apply. (4 points)

Discounted payback method of capital appraisal ignores cash flows beyond the discounted payback period.

The net present value is found by discounting all positive cash flows at the project’s cost of capital.

The project is accepted if the IRR is less than the project’s cost of capital.

The IRR is the discount rate which forces the present value of a project’s future cash flows to equal the future value of its costs.

Firms often choose among mutually exclusive projects on the basis of the present value of future costs.

To use the CAPM approach in capital budgeting, we estimate the firm’s beta, multiply this by the market risk premium and add the firm’s risk premium to the risk-free rate to obtain the firm’s cost of retained earnings or cost of equity.

The best proxy for the risk-free rate is the yield on treasury bonds.

Floatation costs are generally material when looking at its effect on the after-tax cost of debt.

During the last few years, Agile technologies has been too constrained by the high cost of capital to make many capital investments. Recently, though, money costs have been declining, and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department. Assume that you are an assistant to the VP of Finance. Your first task is to estimate Agile's cost of capital. You have been provided with the following data, which may be relevant to your task:

The firm's tax rate is 40 percent.

The current price of Agile's 14 percent coupon, semiannual payment, noncallable bonds with 16 years remaining to maturity is $1,316.05. Agile does not use short-term interest-bearing debt on a permanent basis. New bonds would be privately placed with no flotation cost.

The current price of the firm's 10.5 percent, $100 par value, perpetual preferred stock is $116.67. Agile would incur flotation costs of $2.00 per share on a new issue.

Agile's common stock is currently selling at $42.75 per share. Its last dividend (D0) was $3.82, and dividends are expected to grow at a constant rate of 6 percent in the foreseeable future. Agile's beta is 1.26; the yield on t-bonds is 5 percent; and the market risk premium is estimated to be 5.6 percent. For the bond-yield-plus-risk-premium approach, the firm uses a 3 percentage point risk premium. Agile uses all three estimates of the cost of the common equity component in an equally weighted manner. New common stock would incur a flotation cost of 15%.

Agile's target capital structure is 30 percent long-term debt, 10 percent preferred stock, and 60 percent common equity.

The firm is forecasting retained earnings of $600,000 for the coming year.

Answer the following questions:

1. What is Agile's component cost of debt?

2. What is the firm’s cost of preferred stock?

3. What is Agile's estimated cost of retained earnings using the CAPM approach?

4. What is the estimated cost of retained earnings using the discounted cash flow (DCF) approach?

5. What is the bond-yield-plus-risk-premium estimate for Agile's cost of retained earnings?

6. What is your final estimate for Agile’s cost of retained earnings (ks)?

7. What is Agile's overall, or weighted average, cost of capital (WACC) when retained earnings are used as the equity component?

8. What happens to the cost of equity when retained earnings are used up?

9. At what amount of new investment would Agile be forced to issue new common stock?

10. What is the WACC using new common stock?

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