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What is Cost of Retained Earnings? How does it calculate?


Retained Earnings:
 It is a part of profit which is not distributed among shareholders as dividend.

Cost of Retained Earnings:
It is a require rate of return that shareholders earn as dividend. It is an opportunity cost. There is a question arise “Does it involve cost or not?” because company don’t pay anything for retain earnings to outsiders. But the answer is yes it involve cost. Company reinvests that profit in its business for alternatives opportunities and earns return on it. Due to which shares value are increases in market and shareholders get their required return. The company gets retained earnings after shareholders sacrifice their dividend. So, Cost of retained earnings is a opportunity cost of forgoing dividend. Share holders never get full profit as dividend even if there is 100% payout, because they have to pay tax on their dividend income.

Uses of Retained Earnings:
·         It is helpful to maintain dividend payout ratio in every year.
·         It acts as internal source of finance.
·         It is helpful for company to pay its outside debt.

Disadvantage of Retained Earnings are:
·         Misuse of retained earnings
·         Over-capitalisation means that having more capitals than required for the company which leads to fraudulent activities.

Methods for Retained Earnings:

Methods
Formula
Dividend Discount Model (DDM)
Kre = (D1/NP) + G (1-t) (1-b)
Capital Asset Pricing Model (CAPM)
Kre= rf + b (rm – rf)
Bond Yield plus Risk Premium Approach
Kre = kd + RP

Where,
D1 = Expected dividend
NP = Net Proceeds of retained earnings
G = Growth rate
T =  tax rate
B = purchasing cost of new securities / brokerage cost
Kf = require risk free rate of return
B =  beta of security
Km = require market rate of return 
RP = Risk Premium

Example: Suppose company X declares dividend of Rs.12 per share and expected growth rate is 4%. The net proceeds of the company are Rs.95 and issuing a new securities cost @20%.Find out the cost of retained earnings if company tax rate is 20%.

Solution:
Kre = (D/NP) + G (1-t) (1-b)
= (12 / 95) + 0.48 (1-0.3) (1-0.2)
= 34%

Example: Company Y issues debenture of Rs.100 each at par @ 8% and the risk premium rate is 5%.Find out the cost of retained earnings.

Solution:
Kre = kd + RP
= 8 + 5
= 13%

Example: From the following information find out the cost of retain earnings.

Risk free rate
4%
Market return
12%
Beta
1.2
Dividend per share
Rs.15

Solution:
Kre= rf + b (rm – rf)
= 4% + 1.2 (12%-4%)
=4 + 9.6
=13.6%

Example: Company Y manufacturing toys issues 50 Debentures @7% of Rs. 1000 each to be in a market where risk premium is 4% annually. Company decided to start a new branch which sells all occasion greeting cards but the company is not able to raise further money from outsiders. So, it is decided by the company to internal finance its new project. Find out the cost of retained earnings of company Y if the tax rate is 30%.

Solution:
Kre = kd + RP
 = 7 + 4
= 11%             











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