Cost of Retained Earnings
COST OF RETAINED EARNINGS
Retained earnings are organizations’ own profit reserves, which are not distributed as dividend. These are kept to finance long-term as well as short-term projects of the organization. It is argued that the retained earnings do not cost anything to the organization. It is debated that there is no obligation either formal or implied, to earn any profit by investing retained earnings.
However, it is not correct because the investors expect that if the organization is not distributing dividend and keeping a part of profit as reserves then it should invest the retained earnings in profitable projects. Further, the investors expect that the organization should distribute the profit earned by investing retained earnings in the form of dividend.
Cost of retained earnings can be calculated with the help of various approaches, which are as follows:
(a) KE = KR Approach
Assumes that if the profit earned by an organization is not retained but is distributed as dividend, then the shareholders would invest this dividend in other projects to earn further profit. If an organization retains the dividend then it prohibits the shareholders from earning more profit.
Therefore, for retaining the dividend, the organization should earn the profit, which the shareholders would have earned by investing the dividend in other projects. Therefore, the amount of profit expected from the organization on retained earnings is the cost of retained earnings.
(b) Soloman Erza Approach
Includes the two options that an organization has that is either to retain the earnings to meet future uncertainties or invest in its or other organization’s projects.
The cost of retained earnings can be measured as follows:
(i) Where there are no taxes and brokerage fees
Kr = Ke = D1 + g
Kr = Cost of retained earnings
Ke = Cost of equity capital
D1 = Expected Dividend at the end of Year 1
P0 = Current price of the stock
g = Growth rate
(ii) Where there are taxes and brokerage fees
Kr = Ke (1 – T) (1 – B)
T = Marginal tax rate of shareholder and
B = Brokerage or commission to acquire new shares.