5 The cost of retained earnings Aa Aa True or False It is fr

5. The cost of retained earnings Aa Aa True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders. False True The cost of equity using the CAPM approach The current risk-free rate of return (Rp) is 3.86%, while the market risk premium is 5.75%, the Jefferson Company has a beta of 0.78. Using the Capital Asset Pricing Model (CAPM) approach, Jefferson\'s cost of equity is The cost of equity using the bond yield plus risk premium approach The Jackson Company is closely held and, therefore, cannot generate reliable inputs with which to use the CAPM method for estimating a company\'s cost of internal equity. Jackson\'s bonds yield 10.28%, and the firm\'s analysts estimate that the firm\'s risk premium on its stock over its bonds is 3.55%. Based on the bond-yield-plus-risk-premium approach, Jackson\'s cost of internal equity is: ? 13.14% ? 13.83% ? 15.21% ? 17.29%

Solution

1. It is not true. The cost of retained earning must be at least equal to shareholders rate of return on re-investment of dividend paid by the company. Reason is that shareholders of the company that retains more profit expect more income in future than the shareholders of the company that pay more dividend and retains less profit. Therefore, there is an opportunity cost of retained earnings. Therefore, retained earnings is not a cost free source of financing. The answer is \"False\".