Cost of Retained Earnings
For many companies, a large portion of their financing of investment projects comes from retained earnings. The cost associated with retaining part of current earnings are not always abvious. There is often a mistaken view of treat these funds as cost-free. Often a mistaken view of treat these funds as cost-free. Retained earnings, in fact, are not without cost. Though it might seem that these funds as cost-free. Retained earnings, in fact, are not without cost. Though it might seem that these funds are free, yet there is a very definite opportunity cost involved. The cost of reinvested profits to shareholders is the opportunity cost involved. The cost of reinvested profits to shareholders is the opportunity cost of such funds to them, shareholders are deprived of the current dividends that could have been paid with those earnings,. Opportunity cost is equal to the income that they would otherwise obtain by placing these funds in alternative investments.
In the absence of taxation, the minimum cost of relating these earnings is the cost of equity capital ( ) based on current market price of equity share, as it represents the return that investors expect to receive with the some degree of risk. With taxation, however, the shareholder will have use not of the entire distribution of earnings but only of the portion that remains after personal income taxes. Thus, the opportunity cost of retained earnings to the shareholders in the rate of return that they can obtain by investing the after-tax dividends in alternative opportunities of equal quality.
For example, if a shareholders is in 30% tax bracket, he will have use of only 70% of dividend, (I-T) D. in addition to invest in some other security, he will have to pay brokerage commissions, etc. The total return he is able to achieve by investing the dividend in the share of company of identical risk, can be mathematically expressed thus (Van Horne).
R + K0 (I –T) (I –B)
Where T is shareholders marginal tax rate B is the brokerage and Ke is the minimum cost of retained earning in the absence of taxation (i.e., the cost of equity capital). IF ke is 12% T is 40% and B is 3% his expected return is :
R = 0.12 (1-0.39) (1 – 0.03) = 8.15%
Note that if the company has the shareholder’s interest at heart, it will retain extra earnings only when the money can be invested projects that will lift the shares of company by above 8.15 percent. Generally, retained earnings are a cheaper source funds than equity or preference shares. The main reason is that there is no floatation costs incurred when profits are retained another reason is that personal income tax.
The main difficulty in this approach lies, in determining the marginal rate of tax for all shareholders and resolving difference in this tax rate. Such estimates are extremely difficult, as there are a large number of shareholders within different tax brackets. With different T. cost of retained earnings will also be different, For non-taxable shareholder, the minimum required return would be equal to Ke adjusted for B brokerage and commission. If any, The management has to exercise its judgement in selecting the marginal tax of typical shareholders-a difficult task of course.
Some financial analysis therefore, do not see the need for adjusting the market capitalization rate (Ke) for shareholders tax liability thereby suggest that the cost of retained earnings is the same as K or cost of equity capital. The argument in favour of this approach is that here we should measure the cost of opportunity cost of the company and not the shareholders.