Cost of Retained Earnings & External Equity
The cost of retained earnings or internal accruals is in general taken to be the same as the cost of equity.i.e., kr representing cost of retained earnings = ke
But when for raising external equity, the company has identified floatation monetary value(monetary value incurred during public issue, like brokerage, underwriting commission, fees to managers of issue, legal charges, advertisement and printing expenses etc.). The formula for ke in this will be as follows:
ke= _kr1___
P1-f
Where f = floatation costs.
Cost of retained earnings (ks) is the return stockholders need on the company's common stock.
There are 3 ways one can employ to derive the cost of retained earnings:
i) Capital-asset-pricing-model (CAPM) approach
ii) Bond-yield plus-premium approach
iii) Discounted cash flow approach
Equity finance may be incurred in two ways:
a) By utilizing Retained Earnings
b) By issue of additional equity.
The return or cost of equity required by equity shareholders is the similar in both cases. Irrespective of whether a company raises equity finance either by additional equity or retained earnings, in both the cases the cost of equity is the same. The only difference is floatation costs. There are no floatation costs for retained earnings whereas there is a floatation cost of 2 to 10% for additional external equity.
The companies do not usually distribute the entire profits earned by them via dividend among their share holders. Some profits are kept by them for future elaboration of the business. The cost of retained earnings is the earnings bygone by the share holders. In other sense, the opportunity cost of retained earnings may be considered as the cost of retained earnings. It is equal to the income that the share holders could have gained by placing these funds in optional investments.
Retained earnings act as a source of finance for investment proposals differ from other sources such as debt and equities. There are two chances for the retention of earnings:
a) The amount retained would have been distributed to the share holders who would invest it and yield a return on it.
b) The firm could utilize them in external investment opportunities.
There could be two possible ways to evaluate the cost of retained earnings. The first of these criteria is based on what share holders are able to receive on other investments. The second way is expressed as "external yield criterion.
The cost of retained earnings can be evaluated as specified below:
Case1: When there are no taxes and brokerage fees:
Kr = Ke = D1 + g
P0
Here:
Kr= Cost of retained earnings
Ke= Cost of equity capital
D1= anticipated Dividend at the end of Year 1
P0= Current price of the stock
g= Growth rate
Case 2: When there are taxes and brokerage fees:
Kr = Ke (1 - T) (1 - B)
Here:
T= Marginal tax rate of shareholders and B= Brokerage or commission to acquire new shares.
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