Question

The cost of capital for retained earnings is a market driven b. calculated using the Geurts Valuation Model ( GVM). c affected by the tax rate of the firm d. subject to flotation costs. e difficult to estimate. 9 Nagel Equipment has a beta of 0.88 and an expected dividend growth rate of 4.00 % per year. The T-bill rate is 4.00%, and the T-bond rate is 5.25%. The annual return on the stock market during the past 4 years was 10.25%. Investors expect the average annual future return on the market to be 12.50%. Using the SML, what is the firm's required rate of return? 10. a 11.34% b 11.63% c 11.92% d 12.22% 12.52%

Answer 1

In case of multiple questions only first will be answered

a) Market driven

RE depends upon what market and growth strategy a company chooses to opt for.

A growth-focused company may not pay dividends at all or pay very small amounts, as it may prefer to use the retained earnings to finance activities like research and development, marketing, working capital requirements, capital expenditures and acquisitions in order to achieve additional growth. Such companies have high RE over the years. A maturing company may not have many options or high return projects to use the surplus cash, and it may prefer handing out dividends. Such companies have low RE.

There are no flotation costs for retained earnings

The cost of retained earnings can be measured as follows:

• Where there are no taxes and brokerage fees:
  
  Kr = Ke = D1 + g
                    P0
  Where:
  
  Kr    = Cost of retained earnings
  Ke    = Cost of equity capital
  D1    = Expected Dividend at the end of Year 1
  P0     = Current price of the stock
  g       = Growth rate
  
• Where there are taxes and brokerage fees:
  
  Kr = Ke (1 - T) (1 - B)
  
  Where:
  T    = Marginal tax rate of shareholder and
  B    = Brokerage or commission to acquire new shares.

Tax rate of the firm might not be relevant in RE because it only after the payment of tax when the company has an option to pay dividend or retain its profit for future use.