What is the Cost of Retained Earnings?
The Cost of Retained Earnings (CRE) is the opportunity cost of reinvesting a company's earnings rather than distributing them as dividends. It’s essentially the rate of return that equity shareholders expect, as these retained earnings belong to them.
While CRE doesn’t involve direct cash outflow (unlike debt or preference shares), it still carries an implied cost—the foregone returns shareholders could earn elsewhere.
Why is the Cost of Retained Earnings Important?
- Investment Decisions: It influences the weighted average cost of capital (WACC) and helps assess the feasibility of new projects.
- Shareholder Expectations: Ensures that the company reinvests earnings at a rate acceptable to shareholders.
- Opportunity Cost: Reinforces the principle of maximizing shareholder wealth.
Formulas for Cost of Retained Earnings
There are multiple methods to calculate CRE. Let’s explore them in detail:
1. Dividend Discount Model (DDM) Without Growth
If the company’s dividends are stable, the formula is:
2. Dividend Discount Model (DDM) With Growth
For companies with a steady dividend growth rate, use:
Where:
- Dividend = Annual dividend per share
- Market Price = Current market price of the share
- Growth Rate = Expected rate of growth in dividends
3. Earnings Price Ratio
This method relates earnings directly to market price:
4. Capital Asset Pricing Model (CAPM)
CAPM incorporates market risk and is useful for companies in volatile markets:
Example Calculations
Let’s solidify our understanding with examples.
Example 1: DDM Without Growth
A company pays a dividend of ₹10 per share, and the current market price is ₹200.
The cost of retained earnings is 5%.
Example 2: DDM With Growth
A company pays a dividend of ₹8 per share, the market price is ₹160, and the expected growth rate is 6%.
The cost of retained earnings is 11%.
Example 3: Earnings Price Ratio
If the Earnings Per Share (EPS) is ₹12 and the market price is ₹150:
The cost of retained earnings is 8%.
Example 4: Using CAPM
Assume the following:
- Risk-Free Rate = 6%
- Beta = 1.2
- Market Return = 12%
The cost of retained earnings is 13.2%.
Factors Influencing Cost of Retained Earnings
| Factor | Impact |
|---|---|
| Market Conditions | Higher market volatility increases CAPM-based CRE. |
| Dividend Policy | Consistent dividend payments make DDM more reliable. |
| Company Performance | Strong earnings growth lowers CRE as shareholders’ confidence increases. |
| Risk-Free Rate | Higher rates increase CAPM-based CRE. |
Impact of Growth Rate on DDM-Based CRE
| Growth Rate (%) | CRE (%) |
|---|---|
| 0% | 5% |
| 3% | 8% |
| 5% | 10% |
| 7% | 12% |
As the growth rate increases, the cost of retained earnings rises proportionally.
Cost of Retained Earnings vs. Cost of Equity
| Aspect | Cost of Retained Earnings | Cost of Equity |
|---|---|---|
| Nature | Implied/Opportunity cost | Explicit cost (e.g., dividend payments). |
| Cash Flow | No cash outflow involved. | Involves direct payments to shareholders. |
| Calculation Methods | DDM, EPS ratio, or CAPM. | Similar methods, but explicit focus on dividends. |
Importance for UGC NET Aspirants
- Numericals: Practice is key! DDM and CAPM-based numericals are common in exams.
- Conceptual Clarity: Understand why retained earnings have a cost. It’s all about opportunity cost.
- Comparison Skills: Be prepared to compare CRE with cost of equity or debt in MCQs.
Exam Tip
When solving CRE questions, read carefully whether the problem assumes growth in dividends or not. Misinterpreting growth assumptions can lead to incorrect answers.