Cost of retained earning or Cost of equity captial (Ks)

If stock is in equilibrium, k_s = expected rate of return by investors E(k_s).
Where: K_s – internal equity or required rate of return for common stock.

CAPM approach:

Cost of retained earnings = RFR + (Market rate – RFR) x Beta.

Difficulties:
· don’t know whether use ST or LT treasury rate as risk free rate
· hard to estimate β
· hard to estimate risk premium

Dividend yield plus growth approach:

Required rate of return = D1/P + g.
Growth (g) = ROE(1 – dividend payout ratio)

Bond yield plus risk premium approach:

Required rate of return = (LT debt) Bond yield + Equity risk premium.

Cost of external equity (Ke)

Ke = D1/[P x (1 – % flotation cost)] + g

Where: K_e- external equity, issue new stock, usually >ks

If the firm does not earn at ke for new fund, its stock price will decrease and lead to dilutiion of earning