The part of income which a firm is left with after paying interest on debt capital and dividend to its shareholders is called retained earnings.
The part of income which a firm
is left with after paying interest on debt capital and dividend to its
shareholders is called retained earnings. These also involve cost in the sense
that by withholding the distribution of part of income to shareholders the
firms is denying them the opportunity to invest these funds elsewhere and earn
income. In this sense the cost of retained earnings is the opportunity cost.
It must be noted that retaining
the earnings is equal to forcing the shareholders to increase their equity
position in the firm by that amount. But retained earnings are cheaper when it
is realised that shareholders would have to pay personal tax on the additional
dividends, if distributed. Retained earnings avoid the payment of personal
income tax on dividends and the brokerage fee connected with any reinvestment.
However, the amount to be paid as personal income tax differs from shareholder
to shareholder, depending upon the tax bracket to which he belongs. Thus,
before-tax cost of retained earnings (Cre) and before-tax cost of equity capital (Ce) are equal; but once the impact
of tax is also included then the cost of retained earnings is less than the
cost of equity capital, the difference being the personal income tax. For
example, assume that the company has Rs. 100 of retained
earnings and that there is a uniform personal income tax rate of 30 per cent.
This means that if to shareholders are distributed Rs. 100 of retained
earnings, their income would in fact increase by Rs. 70 (= Rs. 100 - Rs. 30).
In other words, the after-tax opportunity cost of retained earnings is Rs. 70.
Or, the cost of retained earnings is about 70% of the cost of equity capital.
Though the cost of retained
earnings is always lower than cost of equity capital, a company can depend upon
this source of finance only to the extent of availability of funds and
willingness of shareholders. The cost of retained earnings can be stated with
the help of the following formula:
Where, Cre is
the cost of retained earnings; E is
the earnings per equity; Tp is
the personal income tax; and MP is the market price of the share.
Tags : Financial Management - Capital Budgeting – A Conceptual Framework
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