12-22 The earnings, dividends, and stock price of Talukdar Technologies Inc. are expected to grow at 7 percent per year in the future. Talukdar's common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year. a. Using the discounted cash flow approach, what is its cost of retained earnings? b. If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what is the firm's cost of equity using the CAPM approach? If the firm's bonds earn a return of 12 percent, what is r, using the bond- yield-plus-risk-premium approach? (Hint: Use the midpoint of the risk premium range discussed in the chapter.) C. d. Based on the results of parts (a) through (c), what would you estimate Talukdar's cost of retained earnings to be?
12-22 The earnings, dividends, and stock price of Talukdar Technologies Inc. are expected to grow at 7 percent per year in the future. Talukdar's common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year. a. Using the discounted cash flow approach, what is its cost of retained earnings? b. If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what is the firm's cost of equity using the CAPM approach? If the firm's bonds earn a return of 12 percent, what is r, using the bond- yield-plus-risk-premium approach? (Hint: Use the midpoint of the risk premium range discussed in the chapter.) C. d. Based on the results of parts (a) through (c), what would you estimate Talukdar's cost of retained earnings to be?
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Concept explainers
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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On an excel Spreadsheet, do the following problem
Transcribed Image Text:**Cost of Retained Earnings**
**12-22** The earnings, dividends, and stock price of Talukdar Technologies Inc. are expected to grow at 7 percent per year in the future. Talukdar's common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year.
a. Using the discounted cash flow approach, what is its cost of retained earnings?
b. If the firm's beta is 1.6, the risk-free rate is 9 percent, and the average return on the market is 13 percent, what is the firm's cost of equity using the CAPM approach?
c. If the firm's bonds earn a return of 12 percent, what is \( r_s \) using the bond-yield-plus-risk-premium approach? *(Hint: Use the midpoint of the risk premium range discussed in the chapter.)*
d. Based on the results of parts (a) through (c), what would you estimate Talukdar's cost of retained earnings to be?
![**Bond-Yield-Plus-Risk-Premium Approach (\( r_s = r_d + \text{RP} \))**
The bond-yield-plus-risk-premium approach allows analysts to estimate a firm's cost of common equity by adding a risk premium of 3 to 5 percentage points to the before-tax cost of debt. It's based on the idea that firms with risky, low-rated, high-interest-rate debt will likely have risky, high-cost equity as well. This approach simplifies estimating the cost of retained earnings by adding a risk premium to easily observable debt costs.
**Example Calculation:**
For instance, Daflex’s cost of equity might be estimated as follows:
\[
r_s = \text{Bond yield} + \text{Risk premium} = r_d + \text{RP} = 10.0\% + 4.0\% = 14.0\%
\]
In this example, the bond yield (\( r_d \)) is 10.0%, and the risk premium is 4.0%, resulting in a cost of equity (\( r_s \)) of 14.0%.
Since the 4% risk premium is a subjective estimate, the estimated \( r_s \) is also subjective. Empirical research suggests that the risk premium over a firm’s bond yield typically ranges from 3 to 5 percentage points. This method doesn't precisely pinpoint the cost of equity but provides a good estimate.
**Summary of Methods:**
To determine the cost of retained earnings, which should ideally be a single figure, three methods were used:
1. The CAPM method resulted in 13.5%.
2. The constant growth model (DCF approach) resulted in 14.5%.
3. The bond-yield-plus-risk-premium approach resulted in 14.0%.](/v2/_next/image?url=https%3A%2F%2Fcontent.bartleby.com%2Fqna-images%2Fquestion%2F6cf9dff6-12f1-499a-ae5e-c499eec86ad4%2F37c7db82-70bc-47ec-9db4-dca2a4a4e643%2Ffoxsurg_processed.png&w=3840&q=75)
Transcribed Image Text:**Bond-Yield-Plus-Risk-Premium Approach (\( r_s = r_d + \text{RP} \))**
The bond-yield-plus-risk-premium approach allows analysts to estimate a firm's cost of common equity by adding a risk premium of 3 to 5 percentage points to the before-tax cost of debt. It's based on the idea that firms with risky, low-rated, high-interest-rate debt will likely have risky, high-cost equity as well. This approach simplifies estimating the cost of retained earnings by adding a risk premium to easily observable debt costs.
**Example Calculation:**
For instance, Daflex’s cost of equity might be estimated as follows:
\[
r_s = \text{Bond yield} + \text{Risk premium} = r_d + \text{RP} = 10.0\% + 4.0\% = 14.0\%
\]
In this example, the bond yield (\( r_d \)) is 10.0%, and the risk premium is 4.0%, resulting in a cost of equity (\( r_s \)) of 14.0%.
Since the 4% risk premium is a subjective estimate, the estimated \( r_s \) is also subjective. Empirical research suggests that the risk premium over a firm’s bond yield typically ranges from 3 to 5 percentage points. This method doesn't precisely pinpoint the cost of equity but provides a good estimate.
**Summary of Methods:**
To determine the cost of retained earnings, which should ideally be a single figure, three methods were used:
1. The CAPM method resulted in 13.5%.
2. The constant growth model (DCF approach) resulted in 14.5%.
3. The bond-yield-plus-risk-premium approach resulted in 14.0%.
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