The companies do not generally distribute the entire profits earned by them by way of dividend among their shareholders. Some profits are retained by them for future expansion of the business. Many people feel that such retained earnings are absolutely cost free. This is not the correct approach because the amount retained by company, if it had been distributed among the shareholders by way of dividend, would have given them some earning. The company has deprived the shareholders of this earnings by retaining a part of profit with it. Thus, the cost of retained earnings is the earning forgone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of the retained earnings. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments. For example, if the shareholders could have invested the funds in alternative channels, they could have got a return of 10%. This return of 10% has been forgone by them because of the company is not distributing the full profits to them. The cost of retained earnings may, therefore, be taken at 10%.
The above analysis can also be understood in the following manner. Suppose the earnings not retained by the company is passed on to the shareholders, and are invested by the shareholders in equity shares would be taken as the opportunity cost of the retained earnings. In other words, if earnings were paid as dividends and simultaneously an offer for the right shares was made, the shareholders would have subscribed to the right shares on the expectation of certain return. This expected return can be taken as the cost of retained earnings of the company.
In the example given above, we have presumed that the shareholders will have with them the amount of retained earnings available when distributed by the company. In actual practice, it does not happen. The shareholders have to pay tax on the dividends received, incur brokerage cost for making investments, etc. The funds available with the shareholders are, therefore, less than what they would have been with the company, had they been retained by it. On account of this reason, the cost of retained earnings to the company would be always less than the cost of new equity shares issued by the company
The following adjustments are made for ascertaining the cost of retained earnings:
- Income tax adjustment: The dividends receivable by the shareholders are subject to income tax. Hence, the dividends actually received by them are not the amount of gross dividends but the amount of net dividend, i.e., gross dividends less income tax.
- Brokerage cost adjustment: Usually, the shareholders have to incur some brokerage cost for investing the dividends received. Thus, the funds available with them for reinvesting will be reduced by this amount.
The opportunity cost of retained earnings to the shareholders is, therefore, the rate of return that they can obtain by investing the net dividends (i.e., after tax and brokerage) in alternative opportunity of equal quality.
The cost of retained earnings after making adjustment for income tax and brokerage cost payable by the shareholders can be determined according to the following formula:
Kr = Ke(1-T) (1-B)
Where,
- Kr= Required rate of return on retained earnings.
- Ke= Shareholder’s required rate of return.
- T= Shareholders’ marginal tax rate.
- B= Brokerage cost.
The computation of the cost of retained earnings, after making adjustment for tax liabilities, is a difficult process because personal income tax rates will differ from shareholder to shareholder. Thus, it will be necessary to find out the personal income-tax rates of the different shareholders of the company in case cost of retained earnings it to be calculated according to the above approach. In case of a widely held public company, there are a large number of shareholders of varying means and incomes. It is, therefore, almost impossible to determine a single tax rate that would correctly reflect the opportunity cost of retained earnings to every shareholder. Even computation of a weighted average tax would also not give satisfactory results. Some authorities have, therefore, recommended the use of another approach termed by them as external yield criterion. According to this approach the opportunity cost of retained earnings is the rate of return that can be earned by investing the funds in another enterprise by the firm. Thus, according to this approach, the cost of retained earnings is simply the return on direct investment of funds by the firm and not what the shareholders are able to obtain on their investments. The approach represents an economically justifiable opportunity cost that can be applied consistently. Moreover, the need for determining the marginal tax rate for investors will not arise in the case of this approach.