Calculating the Cost of Retained Earnings

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The cost of existing common stock, or retained earnings, is one of four possible direct sources of capital for the business firm. The others are debt capital, preferred stock, and new common stock. The weighted average cost of these sources of capital makes up the weighted average cost of capital for the company with only a few exceptions. The calculations for debt capital and the cost of new common stock are relatively straightforward.

Only the cost of retained earnings is a bit more complex.

What Are Retained Earnings?

Retained earnings, used as a part of the capital structure of a business firm, are the part of the earnings available to common shareholders not paid out as dividends or the earnings plowed back into the firm for growth. As such, their cost to the firm is an opportunity cost. In other words, they could have paid the money out as dividends to the shareholders of the firm but chose instead to put it back into the firm for growth and use it as part of their capital structure.

Calculating Retained Earnings

How do you calculate the cost of retained earnings for a company? It is more difficult to estimate the cost of retained earnings or common stock than it is the cost of debt or the cost of preferred stock. Debt and preferred stock are contractual obligations and have easily determined costs. Retained earnings are different though there are good methods to use to approximate their costs.

Business owners or financial analysts generally use three methods to calculate the costs of retained earnings and then average the results to come up with the answer. Here are the three methods used to calculate the cost of retained earnings:

1. Discounted Cash Flow (DCF) Method

When an investor buys a stock, that investor expects to receive two types of return from that stock - dividends and capital gains.

Dividends are the return firms pay out to their investors quarterly and capital gains, usually the preferred return for most investors, are the difference between what an investor pays for the stock and what they can sell the stock for.

You now have the three variables that you need for the discounted cash flow method of calculating the cost of retained earnings - price of the stock, the dividend paid by the stock, and the capital gain paid by the stock. Of these three, the capital gains, also called the growth rate of the dividends, is the most difficult to measure. We measure the capital gains rate in an earlier article.

The discounted cash flow model for measuring the cost of retained earnings is:

Return on Stock = D1/P0 + g = ____ % = Cost of Retained Earnings

where: D1 is the dividend paid in the first quarter

P0 is the price of the stock

g is the growth rate of the stock (capital gains rate)

2. Capital Asset Pricing Model Method

The Capital Asset Pricing Model is a simple financial model that measures the required rate of return on a stock. It can be used to measure the cost of common stock or retained earnings.

  • The first step is to estimate the risk-free rate currently in the economy.
  • The second step is to estimate the return on the market. Choose a proxy for the market such as the Wilshire 5000 or the Standard and Poor's 500.
  • The third step is to estimate the stock's beta. Beta is a measure of risk with the beta of the market being 1.0. You can find the beta of many stocks from beta books or you can calculate beta as we did in a previous article.

If you have gone through steps 1 through 3, you have all the information you need to calculate the Capital Asset Pricing Model.

Here is the Capital Asset Pricing Model (CAPM):

Required Return on Stock = Risk-free rate + Beta (Market Rate of Return - Risk-free Rate)

3. Bond Yield Plus Risk Premium Approach

The bond yield plus risk premium approach to calculating the cost of retained earnings is a simple method of estimating the cost off the cuff.

The business owner or financial manager simply takes the interest rate on the firm's bonds and adds a risk premium of usually 3 to 5 percent to the bond interest rate, based on their judgment of their firm's riskiness.

After calculating the cost of retained earnings using all three methods, average your three answers and the average is used as the cost when calculating the weighted average cost of capital.