Page 62 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

? Notes
Did u know? Cost of retained earnings = Required rate of return on equity
Corporate executives and some analysts too normally consider retained earnings as cost free,
because there is nothing legally binding the firm to pay dividends to equity shareholders and

the company has its own entity different from its stockholders. But it is not so. They involve
opportunity cost. The opportunity cost of retained earning is the rate of return the shareholder
forgoes by not putting his/her funds elsewhere, because the management has retained the funds.
The opportunity cost can be well computed with the following formula.
⎛ ( 1− T )⎞
K re = K ⎜ i ) ⎟ ⎟ × 100
e ⎜
⎝ ( 1− T b ⎠
Where,
K = Cost of equity capital [D ÷ P or E/P + g].
e
T = Marginal tax rate applicable to the individuals concerned.
i
T = Cost of purchase of new securities/broker.
b
D = Expected dividend per share.
NP = Net proceeds of equity share/market price.

g = Growth rate in (%).
Illustration 1: A company paid a dividend of ` 2 per share, market price per share is ` 20, income
tax rate is 60 per cent and brokerage is expected to be 2 per cent. Compute the cost of retained
earnings.
Solution:

)
⎛ D (1 T ⎞
−
K = ⎜ × i ⎟ × 100
)
−
re ⎝ NP (1 T ⎠
b
)
−
⎛ 2 (1 0.60 ⎞
= ⎜ ⎝ 20 × (1 0.02− )⎠ ⎟ × 100
= 0.10 X 0.409 X 100 = 4.1 per cent
Illustration 2: ABC company’s cost of equity (K ) capital is 14 per cent, the average tax rate of
e
individual shareholders is 40 per cent and it is expected that 2 per cent is brokerage cost that
shareholders will have to pay while investing their dividends in alternative securities. What is
the cost of retained earnings?
Solution:
)
⎛ (1 T ⎞
−
K = ⎜ K × i ⎟ × 100
e
re ⎝ (1 T− b )⎠
(1 0.4− )
= 0.14 × × 100
(1 0.02− )
= (0.14 X 0.613) X 100 = 8.6 per cent

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