The cost of retained earnings
/What is Retained Earnings?
Retained earnings is the profits that a company has earned to date, less any dividends or other distributions paid to investors. A reasonable amount of retained earnings is needed to pay for investments in fixed assets and working capital, as well as to convince lenders that a firm is sufficiently stable to take on additional debt. As a company reaches maturity and its growth slows, it has less need for its retained earnings, and so is more inclined to distribute some portion of it to investors in the form of dividends.
What is the Cost of Retained Earnings?
The cost of retained earnings is the cost to a corporation of funds that it has generated internally. If the funds were not retained internally, they would be paid out to investors in the form of dividends. Therefore, the cost of retained earnings approximates the return that investors expect to earn on their equity investment in the company, which can be derived using the capital asset pricing model (CAPM). The CAPM combines the risk-free rate and a stock’s beta to arrive at the cost of equity capital.
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Example of the Cost of Retained Earnings
Egg Enterprises has been operating for four years. In its first year, the company earned a net income of $60,000. In the second year, it earned $80,000, followed by $100,000 in the third year and $90,000 in the fourth year. This brings the total cumulative net income over four years to $330,000. During this same period, Egg distributed dividends to its shareholders amounting to $10,000 in the second year, $15,000 in the third year, and $25,000 in the fourth year, for a total of $50,000 in dividends paid. To calculate retained earnings at the end of the fourth year, the company subtracts total dividends from total net income: $330,000 minus $50,000 equals $280,000. This $280,000 represents the retained earnings, which are the accumulated profits that Egg has kept within the business to reinvest in growth, strengthen its financial position, or use for other corporate purposes.