Cost of Retained Earnings
Undistributed and retained profit is the main source of internal fund. The average cost rate of different sources of fund is known as cost of capital. Cost of capital is only minimum required rate of return to earn on investment and it is not the actual earning rate of the firm.
Retained earnings, used as a part of the capital structure of a business firm, is that part of the earnings available to common shareholders not paid out as dividends or the earnings plowed back into the firm for growth. As such, their cost to the firm is an opportunity cost. In other words, they could have paid the money out as dividends to the shareholders of the firm but chose instead to plow it back into the firm for growth and use it as part of their capital structure.
METHOD OF CALCULATION
Business owners or financial analysts generally use three methods to calculate the costs of retained earnings and then average the results to come up with the answer. Here are the three methods used to calculate the cost of retained earnings:
• Discounted Cash Flow (DCF) Method :
Return on Stock = D1/P0 + g (D1 = Dividend at year end; P0 = Price of a share at beginning of year; g = growth rate)
• Capital Asset Pricing Model Method :
Required Return on Stock = Rf + Beta (Rm - Rf), [Rf =Risk free rate; Rm = Market rate of return]
• Bond Yield Plus Risk Premium Approach :
I + (3% to 5%), (I = Interest rate of firm’s bond; 3% to 5% based on judgment of firm's riskiness is the risk premium added to interest rate.)
Cost of retained Earnings = Average of the results derived out by all the above three
Retained earnings, used as a part of the capital structure of a business firm, is that part of the earnings available to common shareholders not paid out as dividends or the earnings plowed back into the firm for growth. As such, their cost to the firm is an opportunity cost. In other words, they could have paid the money out as dividends to the shareholders of the firm but chose instead to plow it back into the firm for growth and use it as part of their capital structure.
METHOD OF CALCULATION
Business owners or financial analysts generally use three methods to calculate the costs of retained earnings and then average the results to come up with the answer. Here are the three methods used to calculate the cost of retained earnings:
• Discounted Cash Flow (DCF) Method :
Return on Stock = D1/P0 + g (D1 = Dividend at year end; P0 = Price of a share at beginning of year; g = growth rate)
• Capital Asset Pricing Model Method :
Required Return on Stock = Rf + Beta (Rm - Rf), [Rf =Risk free rate; Rm = Market rate of return]
• Bond Yield Plus Risk Premium Approach :
I + (3% to 5%), (I = Interest rate of firm’s bond; 3% to 5% based on judgment of firm's riskiness is the risk premium added to interest rate.)
Cost of retained Earnings = Average of the results derived out by all the above three