3. Retained Earnings
The percentage of net earnings not paid out as dividends.
It is retained by the company to be reinvested in its core business or to
pay debt.
Also known as the “retention ratio” OR “retained surplus”
4. Cost of Retained Earnings
It is the cost for using the available internal funds accumulated for the
shareholders.
It depends on the expectations of the investing shareholders.
The cost of retained earnings is always less than the cost of external equity
due to the existence of transaction and floatation cost.
Hence, Cost of Retained earnings (Kr) = Ke – F
Where, ke = Cost of External Equity
& F = Flotation Costs
5. Can be calculated using CAPM & Dividend Growth model.
CAPM
rs = rf + ( rm- rf) Bs
Dividend growth Model
Kr= (D1/ P0) + g
Where, D1 = Expected Dividend for next year
P0 = Current Market Price
& g = Firm’s constant Growth rate = ROE * Retention Ratio
6. Problem
Given,
Share capital = Rs.10,00,000 (10000@ Rs.100)
10% debt= Rs.8,00,000
Accu. Retained Earnings = Rs.4,50,000
EBIT= Rs.4,00,000
Tax = 40 %
Dividend payout ratio = 40 %
Market Price of share = Rs.125 per share
Additional Capital Required = Rs.5,00,000
Floatation Cost= 5% of FV
Calculate WACC if internal financing is used.
Calculate WACC if new shares are issued.
Calculate WACC if both are equally used for financing.
cfd.xlsx
7. Amortization
The spreading out of capital expenses for intangible assets over a specific period of
time ie the useful life of an asset.
Is similar to depreciation.
Includes the write off of intangible assets like Trademark, Patent, Goodwill etc.
It decreases the profit of the business and facilitates in tax saving.
No real cash flow occurs.
8. How it facilitates Internal financing?
Eg. When Goodwill of Rs. 20,000 is written off
Treatment in Journals would be:
Goodwill Written off A/c Dr. 20,000
to Goodwill A/c Cr. 20,000
Here goodwill written off is treated as yearly expenses that is shown in the
expenses side of the income statement, which decreases the net profit.
9. In Balance Sheet
Liability & Capital
Share Capital ******
RE *******
P/L A/c *******
Assets
Fixed Assets ******
Goodwill ******
(-)written off (20,000) *****
10. Provisions
Amount put aside in your accounts to cover up a future liability.
It is treated as an expense in the books of account and is shown in the liability side
of the balance sheet.
Includes loan loss provisions, bad debts provisions etc.
It is used up when the future liability occurs.
Is summed up every year and if corresponding liability doesn’t occur a huge
amount of money is left unused in the liability column.
11. Inter-Company Funding
Intercompany loans are loans made from one business unit of a company to
another, usually for one of the following reasons:
To shift cash to a business unit that would otherwise experience a cash shortfall
To shift cash into a business unit (usually corporate) where the funds are aggregated for
investment purposes
To shift cash within business units that use a common currency, rather than sending in
funds from a foreign location that will be subject to exchange rate fluctuations
12. Intercompany loans are extremely useful for the following reasons:
It solves the problem of cash surplus in one unit and cash shortage in other units
No credit application is required
The cash can be made available on short notice
May be cheaper than the external financing
These loans are not on strictly commercial terms:
perhaps they bear low or zero interest, or have less formality in their repayment
arrangements
The use of intercompany loans can cause tax problems, since the issuing business
unit should record interest income on the loan, while the receiving unit should
record interest expense - both of which are subject to tax rules.
13. Intercompany loans are recorded in the financial statements of individual business
units, but they are eliminated from the consolidated financial statements of a group
of companies of which the business units are a part.
