Business, 11.11.2020 17:50 arnold2619

The cost of common equity is based on the rate of return that investors require on the company's common stock. New common equity is raised in two ways: (1) by retaining some of the current year's earnings and (2) by issuing new common stock. Equity raised by issuing stock has a(n) cost, re, than equity raised from retained earnings, rs, due to flotation costs required to sell new common stock. Some argue that retained earnings should be "free" because they represent money that is left over after dividends are paid. While it is true that no direct costs are associated with retained earnings, this capital still has a cost, a(n) cost. The firm's after-tax earnings belong to its stockholders, and these earnings serve to compensate them for the use of their capital. The earnings can either be paid out in the form of dividends to stockholders who could have invested this money in alternative investments or retained for reinvestment in the firm. Therefore, the firm needs to earn at least as much on any earnings retained as the stockholders could earn on alternative investments of comparable risk. If the firm cannot invest retained earnings to earn at least rs, it should pay those funds to its stockholders and let them invest directly in stocks or other assets that will provide that return. There are three procedures that can be used to estimate the cost of retained earnings: the Capital Asset Pricing Model (CAPM), the Bond-Yield-Plus-Risk-Premium approach, and the Discounted Cash Flow (DCF) approach.

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