The retained earnings are considered as a specific portion of net income or net loss that is absorbed by an organization instead of disbursing them to its shareholders in the form of ‘dividends’. It should be in our best interest that finance experts assume ‘retained earning’ as an opportunity cost, as it might evoke new ways to utilize the funds for future endeavors.
So that we can also assume that cost of internally generated funds. It is an imputed or opportunity cost or the dividends given up by the common stockholders. It is the rate that investors can earn elsewhere on investments of comparable risk.
The cost of retained earning comes into action whenever there’s a new project to be financed by the managers. Moreover, the companies have adopted a new trend of preferring internal capital sources towards the external capital sources. Overall, it’s a return that each stockholder would require coming out from the company’s purchased stocks.
In a corporate world, where finance has become a mandatory prelude before or after starting the business, there are three different methods of evaluating the cost of retained earnings.
- The Capital and Asset Price Modeling Method
- Bond Yield Plus Premium Method
- The Discounted Cash Flow Method
Each method follows a different equation that are as follows:
- The Capital and Asset Price Modeling Method
Estimating the cost of capital by CAPM approach first we have to find out risk-free rate (Rf) and market’s expected rate of return (Rm). The other thing is beta (bi) that could be calculated amount of the stock’s risk.
Formula for CAPM:
Here, the expected return on stock = Risk Free Rate is added to Beta (Market Rate of Return subtracted by Risk Free Rate.
i.e
Ra = Rf + Ba(Rm – Rf)
- Bond Yield Plus Premium Method
Here, a specific interest rate is taken over the firm’s overall bonds in order to add a risk premium of 3-5 percent to the bond’s interest rate. Such method puts light over the organization’s riskiness.
Formula for BYPPM:
Ks = interest rate on overall bonds + risk premium
- The Discounted Cash Flow Method
Here, a difference between how much investment is made to purchase a stock is compared with how much the same stock is being sold for in the market. The ‘Discount Cash Flow Method’ follows a simple formula
Formula for DCFM:
“Return on Stock = D1/P0 + g = ____ % ‘which is equivalent to Cost of Retained Earnings.
Where
D1 = next year dividend
g = (retention rate)(ROE) = (1-payout rate)(ROE)
P0 = price
After evaluating our cost of retained earnings, we compare our answers derived from three different methods to accommodate the calculations being made for weighted average cost of capital.