# Cost of capital estimation 222 there are a number of

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Cost of capital estimation2.22>There are a number of possible methods that can be used tocalculate the cost of retained earnings. These include the:Capital asset pricing model (CAPM) approachDividend yield plus growth rate or discounted cash flow (DCF) approachBond yield plus risk premium approach>Capital asset pricing model (CAPM) approachThe CAPM is a widely recognised model used to estimate required rates ofreturn for securitiesThe model requires measurement of the current or future expected return onrisk-free assets, the market risk premium from investing in risky assets, andthe sensitivity of the relevant stock’s return to movements in the wider marketreturnCost of Retained Earnings (Common Equity) continued
Cost of capital estimation2.23>The CAPM equation is:>where:rRF= the risk-free interest rate (which is normally proxied by a Governmentbond or Treasury note rate)RPM= the expected market risk premium on an average stock = rM– rRFrM= the expected return on the market portfolio (which is normally proxied bythe return on a share-price index, such as the All Ordinaries Index in Australiaor the S&P 500 Index in the US)bi= the beta coefficient for the ithsecurity>The major issue with using the CAPM is obtaining accurate estimatesof the componentsCost of Retained Earnings (Common Equity) continuediRFMRFiMRFsbrrrbRPrr)()(
Cost of capital estimationCost of Retained Earnings (Common Equity) continued2.24
Cost of capital estimationCost of Retained Earnings (Common Equity) continued>ExampleA stock has a required return of 11%, the risk-free rate is 7%, and market riskpremium is 4%.A. What is the stock’s beta?B. If the market risk premium increased to 6%, what would happen to the stock’srequired rate of return? Assume that the risk-free rate and the beta remainunchanged.>Answers:A.B.2.251%4%7%11)Pr(emiumRiskRRfs%13%61%7sR
Cost of capital estimation2.26>The discounted cash flow (DCF) approach makes use of the constantdividend growth model to estimate the required return (cost) of equity>This involves a transformation of the model:>where:P0= the current market price of the stockD1= the dividend expected to be paid at the end of year t, where D1/ P0represents the current dividend yield provided by the stockrs= the require rate of return (cost of retained earnings)g = the expected long-term growth rate in dividends after year t(which istypically estimated based on historical growth trends or using analyst forecastestimates)Cost of Retained Earnings (Common Equity) continuedgExpectedPDrgrDPss0110
Cost of capital estimationCost of Retained Earnings (Common Equity) continued>Example

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