>> April 19, 2010
When a company earns profit, it does not distribute its all profit. Some of profit is retained in the form of reserve. This profit is used for development of company and other productive works. It means retained money is used for more earning of business. So, it will have cost like the cost of equity share capital.
If we have to define it, we can say, it is just minimum rate of return which company should earn on same reserve. Somebody can say that there is no need to calculate cost of retained earning because this cost is not payable in the form of dividend. But in reality, if we think that company is using shareholder fund because all earned profit should be payable as dividend but company is not paying full amount, so shareholders are deserve for getting return on reserved amount.
This is just opportunity cost of the amount which is not given as dividend to shareholders. We can calculate cost of retained earning with following formula. The formula will be same as calculating the cost of equity share capital.
Cost of retained earning =
Expected dividend / Net proceed of retained earning + Growth rate
Expected dividend/ N.P. X ( 1- tax rate ) ( 1- cost of new investment)
You might like: