Cost of Retained Earning

1. Introduction

Retained earnings, the portion of a company's profits not distributed as dividends, represent an internal source of financing for investment proposals. Unlike debt, preference shares, and external equity, retained earnings do not involve a formal arrangement or a contractual obligation to pay a return to providers of capital. However, it is incorrect to assume that they are free. In reality, retained earnings come with an opportunity cost.

2. Key Differences from Other Sources

• Debt: Debt involves a legal obligation to pay a fixed rate of interest and repay the principal.
• Preference Shares: Preference shares carry a similar stipulation as debt, though the payment is for dividends instead of interest, and is not a legal obligation.
• Equity Capital: While not legally obligated to pay dividends, equity shareholders expect returns that influence share prices.

3. Why Retained Earnings Have a Cost

• No Formal Obligation: There is no formal or implied obligation on a firm to pay a return on retained earnings.
• Not Free of Cost: Despite the lack of a contractual payment, retained earnings are not free. They involve a real cost to the company.
• Opportunity Cost: Retaining earnings implies withholding dividends from ordinary shareholders. These foregone dividends represent an opportunity cost for shareholders and also for the firm.

4. Defining the Cost of Retained Earnings

The cost of retained earnings can be defined as the opportunity cost in terms of the dividends foregone or withheld from equity shareholders. The firm has to earn a return equal to what shareholders could have earned, had they been paid out as dividends.

5. External-Yield Criterion

5.1. Concept

The alternative to retained earnings is the external investment of funds by the firm. This means that the opportunity cost of retained earnings is the rate of return that could be earned by investing the funds in another enterprise instead of providing those as dividends.

5.2. How it Works

• The firm estimates the yield it can achieve from external investment opportunities, ensuring these opportunities carry a similar risk level as the firm itself.

5.3. Benefits of this approach

• This external yield gives the opportunity cost of retained earnings.
• The external yield is based on a direct investment of funds by the firm, so the return is not affected by the tax brackets of the shareholders.
• The approach can be consistently applied.

5.4. Measurement

The cost of retained earnings (kr) using the external yield criterion is approximately equal to the cost of equity capital (ke).

• kr is the rate of return that the company could obtain by re-investing those funds itself
• ke is the expected rate of return on equity shares.
• However, kr would likely be lower than ke due to flotation costs and dividend payment taxes which apply to external equity and not to retained earnings.

6. Summary

• The cost of retained earnings represents an opportunity cost in terms of the return the firm could have made by re-investing its profits elsewhere or as a result of withholding dividends that would otherwise be made to the shareholders.
• The rate of return that could be earned by the company by making external investment is known as the external-yield criterion.
• The cost of retained earnings using this approach is likely to be equal to the cost of equity capital (ke) but is lower due to flotation cost and taxes that only apply to external equity and not retained earnings.
• The cost of retained earnings, is in the end, the same as the cost of an equivalent fully subscribed issue of additional shares, which is measured by the cost of equity capital.

7. Conclusion

While retained earnings might appear to be a free source of funds, they actually come with an opportunity cost. This cost is equal to the returns that the company or its shareholders could have earned had those earnings been distributed as dividends or invested in other ventures. Understanding this opportunity cost is vital for making sound capital budgeting decisions.