Key Takeaways:
- Understand the meaning and importance of cost of retained earnings in business finance.
- Learn the precise formula and its adjustments for flotation and opportunity cost.
- Appreciate the practical role of retained earnings in internal financing decisions.
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Every business strives to grow, and growth demands capital. While companies can raise funds through equity, debt, or preference shares, they often rely on an internal source: Retained earnings. But have you ever wondered, what is the Ral cost of using these accumulated profits?
Concept and Significance of Cost of Retained Earnings
Retained earnings represent the portion of net profits that a company keeps after paying dividends to shareholders. These earnings are reinvested in the business instead of being distributed. But why do we talk about a Cost for something that stays within the company?
The cost of retained earnings is essentially an opportunity cost. If profits were paid out as dividends, shareholders could invest that money elsewhere and expect a certain return. By retaining profits, the company must at least match this expected return to justify internal retention. This is why retained earnings are not a free source of capital—they carry a hidden cost that reflects what shareholders forgo by not receiving dividends.
Formula for Cost of Retained Earnings
a. Basic Formula (Dividend Growth Approach)
The most common way to estimate the cost of retained earnings is by using the Dividend Growth Model (also called the Gordon Growth Model):
Cost of Retained Earnings (Kr) = (D1 / P0) + g
Where:
- D1 = Expected dividend per share next year
- P0 = Current market price per share
- g = Expected growth rate in dividends
This formula expresses the cost as the sum of the expected dividend yield and the growth rate of dividends. It answers the question: What return would shareholders expect if they received these funds?
b. Adjusted Formula (Considering Flotation and Opportunity Cost)
When new equity is issued, companies incur flotation costs (such as underwriting fees). Retained earnings avoid these costs, but the opportunity cost remains. Some companies adjust the formula to reflect potential taxes or transaction costs shareholders might face. However, for retained earnings, the focus is on the return shareholders expect, since no flotation cost is involved.
If you wish to adjust for flotation costs (for comparison with new equity), the formula would be:
Cost of New Equity (Ke) = [D1 / (P0 - F)] + g
Where F = Flotation cost per share
But for retained earnings, since F = 0, the basic formula stands. The opportunity cost is always the return shareholders expect elsewhere for similar risk.
Example
Let’s solidify your understanding with a step-by-step example.
- Suppose the current market price of a company’s share (P0) is ₹100.
- The company expects to pay a dividend of ₹5 per share next year (D1).
- The expected annual growth rate of dividends (g) is 6%.
Plug these values into the formula:
Kr = (5 / 100) + 0.06 = 0.05 + 0.06 = 0.11 or 11%
This means the company should generate a return of at least 11% on retained earnings to satisfy shareholder expectations.
Practical Relevance in Internal Financing
a. Role in Capital Structure Decisions
Retained earnings are a primary and preferred source of internal financing for most mature firms. Companies use them to fund expansion, research, and even acquisitions—without diluting ownership or increasing debt. However, managers must evaluate projects using the cost of retained earnings as the minimum acceptable rate of return. If a project can't at least earn this rate, it destroys shareholder value.
b. Comparison with Other Sources of Capital
| Source of Capital | Explicit Cost | Flotation Cost | Risk |
|---|---|---|---|
| Retained Earnings | Opportunity cost (shareholder's expected return) | None | Depends on business risk |
| New Equity | Opportunity cost + flotation cost | Yes | Depends on business risk |
| Debt | Interest expense (after tax adjustment) | Yes (for bonds/loans) | Lower (fixed obligation) |
Notice how retained earnings avoid flotation costs, but the company can't ignore the implicit opportunity cost.
c. Shareholder Perspective
Shareholders expect managers to use retained earnings wisely. If the company can't generate returns at least equal to the cost of retained earnings, shareholders might prefer higher dividend payouts, letting them invest elsewhere. This decision directly impacts shareholder wealth and market perception.
The Cost of Retained Earnings reflects the minimum return a company must earn on reinvested profits to satisfy its shareholders. Calculating and understanding this cost ensures that internal financing decisions align with shareholder expectations and long-term business growth.