Cost of retained earnings

Like other source of fund, retained earning also involves cost. Cost of retained earnings is the opportunity cost of dividends foregone by shareholders.

The amount of undistributed profit which is available for investment is called retained earnings.

Further, If the cash is reinvested, the opportunity cost is the expected rate of return that shareholders could have obtained by investing in financial assets.

It is often used interchangeably with the cost of equity . As it is nothing but the expected return of the shareholders from the investment in shares of the company.

However, normally cost of equity remains higher than the cost of earnings. Due to issue of shares at a price lower than current market price and floatation cost.

Furthermore, formula used for calculation of cost of retained earnings are same as formulas used for calculation of cost of equity.

What is the formula for calculation of cost of retained earnings?

Dividend Price Method:

K_r = D ➗ P

Earning Price method:

K_r = EPS ➗ P

Growth method:

K_r = D₁ ➗ P₀ +g

For the calculation of K_e : P = Net proceeds realized = issue price less floatation cost. But for calculation of K_r : P = current market price.

However, sometimes issue price may also be used. The concept of Floatation cost is not used for the calculation of cost of retained earnings.

Example :

Face value of equity shares of a company is ₹ 10, while current market price is ₹200 per share . Company is going to start a new project , and is planning to finance is partially by new issue and partially by retained earnings. You are required to calculate cost of equity shares as well as cost of retained earnings if issue price will be ₹5 per share. Dividend at the end of first year is expected to be ₹10 and growth rate will be 5%.

K_r = D₁ ➗ P₀ +g = 10 ÷ 200 + 0.05 = 10%

K_e = D₁ ➗ P₀ +g = 10 ÷ 190-5 + 0.05 = 10.41%

If personal income tax is also considered then a shortcut formula may be as follows:

K_r = K_e (1-t_p)(1-f)

Here, t_p is the rate of personal income tax on dividend income by equity shareholders.

Example: Cost of equity of a company is 20%. Rate of floatation cost is 5%. Rate of personal income tax is 30%. Calculate cost of retained earnings.

K_r = K_e (1-t_p)(1-f)

= 20% x (1-0.30) x (1-0.05) =13.3%