Cost of retained earning and common stock

1. Presented BY: Faiz Subhani
Roll num 43
MBA 3.5 3rd morning

2. Corporate
finance
Topics:
 Cost of retained earning
 Cost of common stock

3. Cost Of Retained Earning
Concept
 Remaining portion of earning after paying
dividend
 It is an internal source of long-term financing
 In other words amount available for
reinvestment

4. Concept
 Generally, retained earning is considered as
cost free source of financing
 But It is not a cost free source of
 The cost of retained earning must be at least
equal to shareholders rate of return on re-
investment.

5. Determination Of Cost Of Retained Earning
Note:
In 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.
cost of retained earnings differs from the cost of
equity when
1. there is flotation cost to be paid on re-investment
2. personal tax rate of shareholders exists

6. Determination Of Cost Of Retained Earning
When there is no flotation
Formula
Cost of retained earning=
𝐷1
𝑁𝑃
𝑔
Here,
D1= expected dividend per share
NP= net proceeds
G= growth

7. Determination Of Cost Of Retained Earning
When there is flotation cost
Formula
Cost of retained earning= 𝐾𝑒 1 − fp 1 − tp
Here,
fp = flotation cost on re-investment by shareholders
tp = Shareholders' personal tax rate.

8. Cost of new common stock
Concept
 It is also called cost of external equity
 it is based on the cost of retained earnings
increased for flotation costs

9. Determination of cost of common stock
For a constant-growth company
Formula
 Cost of external equity=kc=
𝐷1
𝑃0 1−𝐹
+ 𝑔
here,
F=
𝑃𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑓𝑙𝑜𝑡𝑎𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑠𝑡𝑜𝑐𝑘 𝑃𝑟𝑖𝑐𝑒

10. Example: cost of newly issued stock
 As in our previous example for Newco, assume
the company's stock is selling for $40, its
expected ROE is 10%, next year's dividend is $2
and the company expects to pay out 30% of its
earnings. Additionally, assume the company has
a flotation cost of 5%. What is Newco's cost of
new equity when growth rate is 7%.
Answer:
kc = 2/40(1-.05)+ 0.07 = 0.123, or 12.3%