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TWO sources of Common Equity

# TWO sources of Common Equity - class In this class we will...

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There are TWO sources of Common   Equity : * Internal Common Equity   (i.e. retained earnings) 2) External Common Equity   (i.e. new common stock issue) Question:  Do these TWO sources have the  same cost? Answer:  It Depends… Since the stockholders  own  the firm’s  retained earnings, the internal equity cost is  simply the  stockholders’      required rate of       return . If managers are investing      stockholders’       funds , stockholders will expect to earn an  acceptable rate of return. Therefore, internal and external equity have  the  same  cost from the stockholders point of

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view in  frictionless  markets  [i.e. no costs or  restraints like taxes, commissions, fees, etc]. What about flotation costs? In the absence of flotation costs,  internal and external equity have  the  same  cost. The cost of  EXTERNAL  equity with  flotation costs is calculable. But, these external equity flotation  costs will have to wait for another

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Unformatted text preview: class. In this class, we will focus on INTERNAL equity. The cost of INTERNAL equity can be calculated in two ways: * Capital Market Analysis (CAPM) * Build-Up Method Capital Asset Pricing Model (CAPM) Suppose the Treasury bond rate is 2.25% , the average return on the S&P 500 index is 8.5% , and Gavin’s Gas, Inc has a beta of 0.97 . According to the CAPM, what should be the required rate of return on Gavin’s Gas, Inc stock? k j = 0.0225 + 0.97*(0.085 - 0.0225) k j = 0.0225 + 0.97*(0.0625) k j = 0.0225 + 0.060625 k j = 0.083125 = 8.31% According to the CAPM, Gavin’s Gas stock should be priced to give a 8.31% return. Suppose the Treasury bond rate is 1.75% , the average return on the S&P 500 index is 7.75% , and Aribelle’s Advertising, Inc has a beta of 1.79 ....
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TWO sources of Common Equity - class In this class we will...

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