Cost of Capital - The Cost of Retained Earnings and The Weighted Average Cost of Capital

Contents
Time Value of Money
Annuities
Perpetuities
Kinds of Interest Rates
Future Value of an Uneven Cash flow
Probability Distribution
Standard Deviation
CAPM
Security Market Line
Bond Valuation
Stock Valuation
Cost of Capital
The Balance Sheet
Financial Terms
Scientific Terms
Disclaimer

Cost of Capital

How can a company raise money to build, for example, a new factory?

What are the Capital Components?

Common Stock
Preferred Stock
Bonds (debt)
Retained Earnings - (profit the company makes, but does not give to the shareholders in the form of dividends)

Each of these components has a cost. We can determine the cost of each capital component.

Cost of Retained Earnings

This is kind of weird to think about. It takes some time to understand so take it slowly. After a company makes money (earnings), who owns that money? The shareholders, right? But when you retain earnings you are not giving the money to the shareholders. You are keeping it. In a way, you are investing it for them in your company. Well those shareholders want some return on that money you are keeping.. How much return do they expect? They want the same amount as if they had gotten the retained earning in the form of dividends, and bought more stock in your company with them. THAT is the cost of retained earnings. You as a financial genius, have to ensure that if you are retaining earning, that the shareholders will get at least as good a return on the money as if they had re-invested the money back into the company.

If you don't understand this, re-read it and re-think it until you do get it. There is really no "cost" in the cost of retained earnings. I mean, no money is changing hands. You aren't paying anyone anything. But you are keeping the shareholders money. You can't say it is "free" money. Frankly if you did, it would screw up your capital budgeting. So when you are doing your capital budgeting, to ensure that the shareholders are getting a decent rate of return, you "guess" a cost of retained earnings. How?? One way is CAPM. Another way is the bond yield plus risk premium approach, in which you take the interest rate on the company's own long term debt and then add between 5% and 7%. Again, you are kind of guessing here. A third way is the discounted cash flow method, in which you divide the dividend by the price of stock and add the growth rate. Again, a lot of guessing.

Cost of Issuing Common Stock

Flotation Cost of Common Stock

Costs of issuing the actual stock (ink, printing, paper, computers, etc.)

The cost of retained earnings.

Cost of Preferred Stock

Cost of Preferred Stock	=	What you give.	divided by	What you get.
Cost of Preferred Stock	=	Dividend	divided by	Price - Underwriting Costs

Cost of Bonds (debt)

Cost of Debt

Coupon rate on the bonds

minus

The Tax Savings

Interest on bonds is tax deductible. So we can reduce our taxable income by the amount of money we pay to the bondholders.

WACC - The Weighted Average Cost of Capital.

Every company has a capital structure - a general understanding of what percentage of debt comes from retained earnings, common stocks, preferred stocks, and bonds. By taking a weighted average, we can see how much interest the company has to pay for every dollar it borrows. This is the weighted average cost of capital.

Capital Component	Cost	Times	% of capital structure	Total
Retained Earnings	10%	X	25%	2.50%
Common Stocks	11%	X	10%	1.10%
Preferred Stocks	9%	X	15%	1.35%
Bonds	6%	X	50%	3.00%
TOTAL				7.95%

So the WACC of this company is 7.95%.

Detailed Explanation

Cost of Retained Earnings - The cost of retained earnings is an important concept in finance that refers to the opportunity cost associated with using earnings to fund future projects or investments rather than distributing them to shareholders as dividends. Retained earnings are a key source of financing for many companies, and understanding their cost is essential for making informed financial decisions.

To understand the cost of retained earnings, it is important to first understand the concept of the cost of capital. The cost of capital is the minimum return that investors require on their investment in a company. It is the cost of financing a company’s operations and projects, and it is used to determine the required rate of return for new investments. The cost of capital is composed of two main components: the cost of debt and the cost of equity. The cost of debt is the interest rate that a company pays on its debt. It is relatively straightforward to calculate, as it is simply the interest rate that the company pays on its outstanding debt. The cost of equity, on the other hand, is a bit more complex to calculate. It is the return that investors require on their investment in the company’s stock, and it is influenced by a variety of factors, including the company’s risk profile, growth potential, and dividend policy. Retained earnings are a component of the cost of equity, as they are an alternative source of financing that can be used to fund new investments or projects. When a company retains earnings, it is effectively reinvesting those earnings back into the company, rather than paying them out as dividends. This means that the cost of retained earnings is the opportunity cost of not distributing those earnings to shareholders as dividends.

One way to calculate the cost of retained earnings is to use the capital asset pricing model (CAPM). The CAPM is a widely used financial model that is used to calculate the expected return on an investment based on the risk-free rate, the expected market return, and the stock’s beta, which measures the stock’s volatility relative to the overall market. To use the CAPM to calculate the cost of retained earnings, we first need to calculate the company’s cost of equity. This can be done using the following formula:

Cost of Equity = Risk-Free Rate + Beta x (Expected Market Return – Risk-Free Rate)

The risk-free rate is the rate of return on a risk-free investment, such as U.S. Treasury bonds. The expected market return is the expected return on the overall stock market, and the beta is the stock’s volatility relative to the overall market. Once we have calculated the cost of equity, we can then use this to calculate the cost of retained earnings. The cost of retained earnings is the return that the company could have earned if it had paid the earnings out as dividends instead of retaining them. This is calculated as follows:

Cost of Retained Earnings = Cost of Equity x (1 – Dividend Payout Ratio)

The dividend payout ratio is the percentage of earnings that the company pays out as dividends. If the company pays out all of its earnings as dividends, the dividend payout ratio is 100%. If the company retains all of its earnings, the dividend payout ratio is 0%.

For example, let’s say that a company has a cost of equity of 10%, and a dividend payout ratio of 50%. The cost of retained earnings for this company would be:

Cost of Retained Earnings = 10% x (1 – 50%) = 5%

This means that the cost of retaining earnings for this company is 5%. In other words, if the company were to distribute all of its earnings as dividends, it would need to earn a return of at least 5% on its investments to compensate for the opportunity cost of not retaining the earnings.

Factors affecting cost of capital - The cost of capital is determined by both debt and equity sources of financing, and it is essential for businesses to understand the factors that affect their cost of capital in order to make informed decisions about financing projects and investments. In this chapter, we will discuss the various factors that can affect a company's cost of capital, including interest rates, inflation, market conditions, and company-specific factors such as credit rating and business risk.

Interest rates are a significant factor in determining a company's cost of capital. Interest rates are determined by various factors, including the demand for credit, inflation expectations, and the Federal Reserve's monetary policy. When interest rates are low, it is generally easier for companies to obtain financing, as the cost of borrowing is lower. This can result in a lower cost of capital for the company. Conversely, when interest rates are high, it can be more difficult and expensive for companies to obtain financing, resulting in a higher cost of capital.

Inflation is another factor that can affect a company's cost of capital. Inflation is the rate at which the general level of prices for goods and services is increasing over time. When inflation is high, the purchasing power of money decreases, and investors require a higher rate of return to compensate for the decreased value of their money over time. This results in a higher cost of capital for the company. Conversely, when inflation is low, investors may require a lower rate of return, resulting in a lower cost of capital for the company.

Market conditions can also affect a company's cost of capital. Market conditions refer to the state of the economy, including factors such as the level of economic growth, the state of the stock market, and the overall business climate. In a strong economy, where there is high demand for goods and services, investors may be more willing to invest in companies, resulting in a lower cost of capital. Conversely, in a weak economy, where there is low demand for goods and services, investors may be more risk-averse, resulting in a higher cost of capital for companies.

A company's credit rating is another important factor that can affect its cost of capital. Credit rating agencies, such as Standard & Poor's, Moody's, and Fitch, assign credit ratings to companies based on their creditworthiness, which is an assessment of the likelihood that the company will default on its debt obligations. A higher credit rating indicates a lower perceived risk of default and can result in a lower cost of capital for the company. Conversely, a lower credit rating indicates a higher perceived risk of default and can result in a higher cost of capital.

Business risk is another company-specific factor that can affect its cost of capital. Business risk refers to the risk that a company's operations will not generate sufficient cash flow to meet its financial obligations. The level of business risk is determined by factors such as the company's industry, competitive position, and operating history. Companies with higher levels of business risk may require a higher rate of return to compensate for the increased risk, resulting in a higher cost of capital. Conversely, companies with lower levels of business risk may require a lower rate of return, resulting in a lower cost of capital.

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Financial Terms: A B C D E F G H I J K L M N O P Q R S T U V W Y Z

About the author

Author: Mark McCracken is a corporate trainer and author living in Higashi Osaka, Japan. He is the author of thousands of online articles as well as the Business English textbook, "25 Business Skills in English".