Question

Question 4: Short Answer F: Suppose your firm is going to finance a new project 100% with retained earnings. Your boss claims that since the earnings are already being retained and that since no outside financing is required, the project should be evaluated at the risk-free rate of return. Is this appropriate? Are retained earnings risk-free? Why or why not?

Answer 1

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.Generally, retained earning is considered as cost free source of financing. It is because neither dividend nor interest is payable on retained profit. However, this statement is not true. 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. Therefore, there is an opportunity cost of retained earning. In other words, retained earning is not a cost free source of financing. The cost of retained earning must be at least equal to shareholders rate of return on re-investment of dividend paid by the company.

Determination Of Cost Of Retained EarningIn the absence of any information relating to addition of cost of re-investment and extra burden of personal tax, the cost of retained earning is considered to be equal to the cost of equity. However, 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 exists.i)Cost of retained earnings when there is no flotation cost and personal tax rateapplicable for shareholders:Cost of retained earnings(kr) = Cost of equity(ke) = (D1/NP)+gwhere,D1= expected dividend per shareNP= current selling price or net proceedii)Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders:Cost of retained earnings(kr) = Cost of equity(ke) x1-fp) (1-tp)where,fp = flotation cost on re-investment(in fraction) by shareholderstp = Shareholders' personal tax rate.