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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

How much would you have to invest today to receive a. $15,000 in 8 years at 10 percent?

You are going to receive $205,000 in 18 years. What is the difference in present value between using a discount rate of 12 percent versus 9 percent?

Question:Surgical Supplies Corporation paid a dividend of $1.12 per share over the last 12 months. The dividend is expected to grow at a rate of 2.5 percent over the next three years (supernormal growth). It will then grow at a normal, constant rate of 7 percent for the foreseeable future. The required rate of return is 12 percent (this will also serve as the discount rate).

a. Compute the anticipated value of the dividends for the next three years (D1, D2, and D3).

b. Discount each of these dividends back to the present at a discount rate of 12 percent and then sum them.

c. Compute the price of the stock at the end of the third year (P3).

P3 = D4/ (Ke - g)

d. After you have computed P3, discount it back to the present at a discount rate of 12 percent for three years.

e. Add together the answers in part b and part d to get the current value of the stock. (This answer represents the present value of the first three periods of dividends plus the present value of the price of the stock after three periods.)

North Pole Cruise Lines issued preferred stock many years ago. It carries a fixed dividend of $6 per share. With the passage of time, yields have soared from the original 6 percent to 14 percent (yield is the same as required rate of return).

a. What was the original issue price?

b. What is the current value of this preferred stock?

c. If the yield on the Standard & Poor鈥檚 Preferred Stock Index declines, how will the price of the preferred stock be affected?

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?
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