Question

The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is 35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport's cost of retained earnings? Select one:
a. 17.7%
b. 20.1%
c. 16.4%
d. 19.6%

Answer 1

Answer:

20.1%

Explanation:

In capital asset prcing model (CAPM), cost of equity (or cost of retained earnings in this context) is calculated as below:

Cost of equity = risk-free rate of return + beta x (market index return - risk-free rate of return)

Please note that (market index return - risk-free rate of return) is equal to market risk premium

Putting all the number together, we have:

Cost of equity/retained earnings = 2.5% + 2.2 x 8% = 20.1%

Note: The dividend growth rate, tax rate & stock standard deviation is not relevant in answering the question.