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Chapter 4: Q11-7DQ (page 360)

Why is the cost of retained earnings the equivalent of the firm鈥檚 own required rate of return on common stock (Ke)?

Short Answer

Expert verified

Since stockholders can earn a return essentially equivalent to their present investment.Thus, the company's rate of return (Ke) serves as a means of approximating the opportunities for different investments.

Step by step solution

01

Introduction to Required rate of return-

The required rate of return is the minimum return an investor will acknowledge for possessing an organization's stock, as compensation for a given level of risk related with holding the stock. The required rate of return is also utilized in financial manamgment of the companies to determine the profitability of investment projects.

02

The cost of retained earnings the equivalent of the firm’s own required rate of return on common stock (Ke)-

In the stock markets, there are numerous of investments from which to choose, so it isn't unlikely to expect the stockholder could take dividend payments and again invest it for a comparable yield.Thus while computing the cost of retained earnings, it takes back to the point of the cost of common stock. The cost of retained earnings is equivalent to the rate of return on common stock of the firm鈥檚 .

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Most popular questions from this chapter

Tom Cruise Lines Inc. issued bonds five years ago at $1,000 per bond. These bonds had a 25-year life when issued and the annual interest payment was then 15 percent. This return was in line with the required returns by bondholders at that point as described next:

Real rate of return ........................ 4%

Inflation premium ......................... 6

Risk premium .............................. 5

Total return ............................... 15%

Assume that five years later the inflation premium is only 3 percent and is appropriately reflected in the required return (or yield to maturity) of the bonds. The bonds have 20 years remaining until maturity. Compute the new price of the bond.

Cal Lury owes $10,000 now. A lender will carry the debt for five more years at 10 percent interest. That is, in this particular case, the amount owed will go up by10 percent per year for five years. The lender then will require that Cal pay off the loan over the next 12 years at 11 percent interest. What will his annual payment be?

Question: You need $28,974 at the end of 10 years, and your only investment outlet is an 8 percent long-term certificate of deposit (compounded annually). With the certificate of deposit, you make an initial investment at the beginning of the first year.

a. What single payment could be made at the beginning of the first year to achieve this objective?

b. What amount could you pay at the end of each year annually for 10 years to achieve this same objective?

Question: Assume $65,000 is going to be invested in each of the following assets. Using Tables 12-11 and 12-12, indicate the dollar amount of the first year鈥檚 depreciation

a. Office furniture.

b. Automobile.

c. Electric and gas utility property.

d. Sewage treatment plant.

Sampson Corp. is evaluating the introduction of a new product. The possible levels of unit sales and the probabilities of their occurrence are shown next:

Possible Market Reaction Sales in Units Probabilities

Low response ....................................... 30 0.10

Moderate response .............................. 50 0.20

High response ...................................... 75 0.40

Very high response ............................... 90 0.30

a. What is the expected value of unit sales for the new product?

b. What is the standard deviation of unit sales?
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