Question

A firm’s return available to shareholders is 15%. The average tax rate of share holders in 40% and it is expected that 2% is brokerage cost that shareholders will have to pay while investing their dividends in alternative securities. What is the cost of retained earnings?

Answer 1

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☞Use the formula for the required rate of return as follows:

Required Rate of Return = Risk-free rate + Beta x (Market rate of return - Risk-free rate)

For example, if you have a risk-free rate of 2 percent, a beta of 1.5, and an expected rate of return on the market of 8 percent, your formula would be as follows:

Required Rate of Return = .02 + 1.5 x (.08 - .02) = .11, or 11 percent

It gives you a cost of retained earnings of 11 percent.

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