MBA Knowledge Base

The cost of equity will rise by an amount just sufficient to offset any possible saving or loss. The supply of debt is determined by the lenders. The optimal level is simply the maximum amount of debt which lenders are prepared to subscribe in any given circumstances. For example, level of inflation, rate of economic growth, level of profits etc. The investors will exercise their own leverage by mixing their own portfolio with debt and equity. They call this the Arbitrage process. Under these conditions of investments the average cost of capital is constant. If two different firms which same level of business risks but with levels of gearing sold for different values, then shareholders would move from overvalued firm to the undervalued firm and adjust their level of borrowings through the market to maintain financial risk at the same level. The shareholders would increase their income through this method. Continue reading

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 Continue reading