Question

A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 12.00%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?

Answer 1

15.85%

Step-by-step explanation:

The return on equity can be calculated using the Capital Asset Pricing Model:

Required Return on Equity = Risk free rate + Risk Premium

Now the economist say that using the cost of debt over risk free rate for estimating the cost of equity is better than using risk free rate. So the equation under this scenario becomes:

Required Return on Equity = Cost of debt + Risk Premium

Now by putting values, we have:

Required Return on Equity = 12% + 3.85% = 15.85%