Methods to calculating the cost of retained earnings or common equity
The BEC section of the CPA exam will test a candidate on how to calculate the weighted average cost of capital for a company. One of the key inputs to calculating the WACC is the cost of retained earnings or cost of common equity. This will be your guide on the three methods that you need to know for the CPA exam. This is also useful for accounting students or accounting and finance professionals looking to simplify the concept.
By calculating the cost of equity for retained earnings, a company understands what type of return investors and the market are requiring owning the company’s stock and bear any risks from own the stock. There are three methods associated with calculating the cost of common equity that you need to understand.
1) Capital asset pricing model (CAPM)
The CAPM is a very popular model as it captures the expected return and the risk of volatility (systematic risk) in those returns. The CAPM helps investors quantify the expected return after factoring in the risk associated with owning a company’s stock. Below is the expanded formula for the CAPM. Let’s run through the key components of the CAPM:
Risk-free rate: The risk-free rate is meant to illustrate the return that investors could receive in an investment that has ZERO risk. The most common investment used for the risk-free rate is a United States treasury bond. The investment is ZERO risk as the investment is backed by the US government. So, unless the US Government collapses, then there is ZERO right.
Beta: The beta is included in the CAPM to account for volatility in expected returns, which is known as systematic risk. A company is assigned a beta that assigns risk of volatility compared to the market. The higher the beta, the riskier and more volatile a company is relative to the markets. Beta can be assessed by calculating the change in a company’s stock (up or down) relative to changes in the overall market.
A beta greater than 1 indicates that the company is riskier and more volatile than the market. A beta equal to 1 indicates the company’s value moves up or down with the overall market. A beta less than 1 means that the company is less volatile or safer than the overall market.
Market risk premium: The market risk premium is calculated as the difference between the market return (average) less the risk-free rate. Think about the market return like the bull on Wall Street and the risk-free rate based on US Government securities like treasury bonds. The difference between the two represents the risk premium that investors are exposing themselves to by investing in equities.
CAPM Example Scenario
Below is an example scenario on how the CAPM can be used to calculate the cost of common equity. The information included in the question is indicative of the information that questions on the CPA exam would need to provide.
2) Discounted cash flow (DCF) method
The discounted cash flows method (DCF) is a valuation method that will be applied to estimate the overall value of a potential investment based on future cash flows. Cost of equity using discounted cash flows can be calculated as follows:
Dividend: Represents the actual or expected dividend for the company at the end of the current year.
Price: Represents the market value or current share price of the company. Share price can be calculated by taking the company’s market value and divided by the current number of shares outstanding.
Growth rate: Represents the expected constant growth rate on the company’s dividend. The idea is that this represents the expected growth rate in the company’s cash flow through the dividend.
Below is an example scenario on how the DCF method can be used to calculate the cost of retained earnings. The idea is that we can calculate the dividend + growth rate to determine the cost of paying a dividend to common shareholders in the future:
3) Bond Yield Plus Risk Premium (BYPRP) Approach
Bond yield plus risk premium associate’s risks with the organization as well as the overall health of the economy. Risk premiums will depend on nondiversifiable risks. This risk premium is not the same as the market risk premium used in the CAPM approach.
Before tax cost of debt: This just represents the cost of debt that the company would have if they were to go the debt financing route.
Risk premium: Represents the return that the market is expected to receive in excess of the risk-free rate (i.e., US government treasury bonds).
Below is an example scenario and how to use the BYPRP approach. In the example, the company issues their own bonds at 8% and represents their cost of debt. We also need to add in an additional risk premium that holders of the bonds would require for the risk that the company defaults.
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