Presented BY: Faiz SubhaniRoll num 43

MBA 3.5 3rd morning

Corporate financeTopics:

Cost of retained earning

Cost of common stock

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

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.

Determination Of Cost Of Retained EarningNote: 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 when1. there is flotation cost to be paid on re-

investment2. personal tax rate of shareholders exists

Determination Of Cost Of Retained Earning

When there is no flotationFormula

Cost of retained earning= Here,D1= expected dividend per shareNP= net proceedsG= growth

Determination Of Cost Of Retained Earning

When there is flotation costFormula

Cost of retained earning= Here,fp = flotation cost on re-investment by shareholderstp = Shareholders' personal tax rate.

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

Determination of cost of common stock

For a constant-growth companyFormula

Cost of external equity=kc=

here,

F=

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%