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L E SS O N - 7

COST OF RETAINED EARNINGS

CHAPTER OBJECTIVES
To learn about the method of calculating cost of Retained Earnings and the Weighted
average cost of capital.
To provide adequate illustrations and solutions to understand the determination of cost
of capital.
STRUCTURE
7.1 Introduction
7.2 Capital Asset Pricing Model
7.3 Weighted Average Cost of Capital
7.4 Book Value Weights Vs. Market Value Weights
7.5 Marginal Cost of Capital
7.6 Summary
7.7 Review Questions
7.8

Key Words

INTRODUCTION
All the profits earned by a company are not distributed as dividends to shareholders.
Generally, companies retain a portion of the earnings for use in business. This is called
retained earnings.
The company does not have to pay any dividend on the retained earnings. Hence, it is
sometimes argued that retained earnings do not have any cost. This view is not correct. If the
amount retained by the company had been distributed to shareholders, they would have
invested the amount elsewhere and earned some return. As the earnings have been retained by
the company the shareholders have foregone the return. Therefore, retained earnings do have a
cost. The cost of retained earnings is the return foregone by shareholders. It is thus, the
opportunity cost of dividends foregone by shareholders.
It is to be noted that the shareholders cannot invest the entire dividend income. They have
to pay income tax on dividends. Further, they have to pay brokerage for purchase of securities,
(for investing the after tax dividends). Therefore, adjustments are made for tax and brokerage in
the computation of cost of retained earnings.

Cost of retained earnings may be ascertained as follows:

Cost of equity capital (Ke)

xxx

Less : Tax on cost of equity

xxx

Less: Brokerage (% on a - b)

xxx

Cost of retained earnings (Kr)

xxx

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Alternatively,
Kr =

Ke (1 - t) (1- b)

Where, Kr = Cost of retained earnings

Ke =

Cost of equity capital

t = Tax rate
b=

Brokerage

Illustration: 1 A Companys cost of equity capital (kc ) is 15 %. The average tax rate
of shareholders is 40 % and the brokerage cost for purchase of securities is 2% calculate
the cost of retained earnings.

Solution
For computing the cost of retained earnings, adjustments for tax and brokerage are
to be made as shown below:
Rs.
Cost of equity capital Ke = 15.00 - Less : Tax at
40 % on 15 = 6.00
9.00
Less Brokerage at 2 % on 9 =

0.18

Cost of retained earnings kr =

8.82

Alternatively,
kr = ke (1 - Tax rate) (1 - Brokerage)
= 15 (1 -0.40) (1 -0.02)
= 15 (0.6) (0.098) = 8.82 %

7.1 CAPITAL ASSET PRICING MODEL (CAPM )

The CAPM approach ccnsiders the risk element in determining the cost of
equity capital. The cost of equity capital is the return required by investors. It has
two elements.
i)
ii)

The risk - free return (Rf)

The premium for risk (Pr)

Thus, the cost of equity capital Ke = Rf + Pr

Premium for the risk (Pr) is the difference between market return from a diversified
portfolio (Rm) and the risk - free return (Rf). It is
Pr = beta (Rm - Rf)

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Where, Pr is the Premium for risk

beta = Beta value, a measure of risk Rm =
Market return Rf = Risk-free return Cost of equity
capital, Ke = Rf + Pr ?Ke = Rf + beta( Rm - Rf)

illustration - 2
The following particulars relate to A Ltd.
1. Risk free return is 10 %
2. Beta co-efficient beta of the company is 1.5
Compute the cost of equity capital using Capital Asset Pricing Model (CAPM) if the
expected market return is 14 %. Also calculate the cost of equity if beta raises to 2.

Solution
Cost of equity capital = Risk free return + Premium for risk
Under CAPM, Premium for risk = beta (Rm - Rf)
= Beta (Market return - risk free return)
Therefore, Cost of equity capital kc = R1 + Beta (Rm - Rf)
= Risk free return + (market return - Risk free return)
= 10 + 1.5 ( 1 4 - 10)
= 10 + 1.5 (4) = 16 %
Cost of equity capital, if beta increases to 2 Cost of equity capital
kc

=10 + 2 ( 1 4 - 1 0 )
= 10 + 2 (4) = 18 %

Note: Beta is a measure of risk. It indicates the market related risk of a security. Beta of a
particular security shows the percentage change in a securitys return for one percentage
change in the market return.
A beta of 1 means that the security as risky as the market. A beta value of less than 1
means that the security is less risky than the market. Beta greater than 1 means that the
security is riskier than the market.

7.2 WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Weighted Average Cost of Capital is veiy important in financial decision making. WACC is
the weighted average of the costs of different sources of finance. It is also known as composite
cost of capital or overall cost of capital.
The steps for the calculation of WACC are:
1.

After tax cost is relevant in financial decision making. Therefore, the after tax cost of
each of the source (x) of finance is ascertained.

2.

Tne proportion of each source in the total capital ( w) is determined. The

proportions are used as weights for finding out WACC.

3.

The cost of each source (x) is multiplied by the appropriate weight (x) x (w)

4.

The total of the weighted costs of each source is the weighted average cost of capital
(WACC = E x w ).

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7.3 BOOK VALUE WEIGHTS VS MARKET VALUE WEIGHTS

In order to calculate the WACC, the proportion of each source of finance in the total
capital is used as weights. To determine the weights, book value or market value may be used.
Theoretically, market value weights are superior as they reflect the expectations of investors.
But in practice, book value weights are widely used. The reasons are :
1.

Book values are readily available.

2.

It is difficult to use market values because of their fluctuations.

3.

Firms use only book values in designing their capital structure.

4.

Equity share capital gets more importance if market values are used.

7.4 MARGINAL COST OF CAPITAL

Very often, companies are concerned with the selection of new projects. Additional funds
are to be raised from different sources to finance these new projects. For making capital
expenditure decisions, it is necessary to find out the cost of additional funds. Marginal cost of
capital is quite useful in this regard.
Marginal cost of capital is the weighted average cost of new, additional or incremental
capital raised by a company.

Illustration - 3
A firm has the following a capital structure and after tax costs.
Rs.
Debt

After tax cost %

8,75,000

Preference capital 6,25,000

12

Equity capital

15

a)

10,0C,000

Calculate the weighted average cost of capital using book value expansion, from the
following sources.

b)

The firm plans to raise an additional sum of Rs. 9,00,000 for expansion, from the
following sources.

Debt

Rs. 4,50,000

Preference capital

2,25,000

Equity capital

2,25,000

The specific costs do not change. Compute the marginal cost of capital.
Solution
Computation of Weighted Average cost of Capital (ko)
Amount
Source of
After tax cost Weighted
* Proportion to
funds
% (x)
% (w) X
Rs.
total (w)
(x)
%

Debt

8,75,000

0.35

2.1

Preference
capital

6,25,000

0.25

12

3.0

Equity capital

10,00,000 0.40

15

6.0

Total

25,00,000

WACC

11.1

cost

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Computation of Weigh* 1 Marginal Cost of Capital

(Cost of additional funds)
Sources of funds
Amount F ^portion ti. After tax cost Weighted cost
% (w) x (x)
total (w)
% (x)
Rs.
Debt

4,50,000

0.50

3.00

2,25,000

0.25

12

3.00

Equity capital

2,25,000

0.25

15

3.75

Total

9,00,000

WMCC

9.75

Preference capital

7.5 SUMMARY
Generally Companies retained a portions of earnings for future use which is called
retained earnings. Some times it is ctrgued that retained earnings have no cost but retained
earnings have a cost since the shareholder have forgone the return of opportunity of dividend
cost retained earnings has been explained through illustration. 1
Capital asset Pricing Model and calculation of weighted average cost of capital marginal
cost of capital have also been explained with proper illustrations.

7.6 REVIEW QUESTIONS

1. What is weighted average cost of capital? How is it determined?
2. How is cost of equity capital determined under CAPM?
3. How will you compute cost of retained earnings?

7.7 KEYWORDS
Capital Assets, Value Weights, Risk - free return.