2. Retained Earnings
The portion of net profit distributed to shareholders is called
Dividend and the remaining portion of the profit is called Retained
earning.
In other word, the amount of undistributed profit which
is available for investment is called Retained earning.
Retained earning is considered as internal source of long-term
financing and it is a part of shareholders equity.
3. Shareholders of the company that retains more profit expect more
income in future than the shareholders of the company that pay more
dividend and retains less profit.
The cost of retained earning must be at least equal to shareholders
rate of return on re-investment of dividend paid by the company.
4. The cost of retained earnings differs from the cost of equity when
there is flotation cost to be paid by the shareholders on re-
investment and personal tax rate of shareholders.
Determination Of Cost Of
Retained Earning
5. i ) Cost of retained earnings when there is no flotation cost and
personal tax rate applicable for shareholders:
Cost of retained earnings = Cost of equity = (D1/NP)+g
where,
D1 = Expected dividend per share
NP = Current selling price or net proceed
g = Growth rate
6. ii) Cost of retained earnings when there is flotation cost
and personal tax rate applicable for shareholders:
Cost of retained earnings =
Cost of equity x (1- fp) (1-tp)
where,
fp = flotation cost on re-investment by shareholders
tp = Shareholders' personal tax rate.
7. Illustration
A company's share are currently selling for Rs120. The expected
dividend and the growth rate are 5.20 and 6% respectively.
Then calculate the cost of retained earning.
Solution,
Cost of retained earning(kr) = (D1/NP)+ g
= (5.20/120) +0.60 = 0.1033 or 10.33%
