Foundations of Financial Management: An Analysis (part 41)

“Every time you borrow money, you’re robbing your future self.” 

– Nathan W. Morris

Cost of Capital (part 3)

by

Charles Lamson

Cost of Retained Earnings

Up to this point, we have discussed the cost (required return) of common stock in a general sense. We have not really specified who is supplying the funds. One obvious supplier of common stock equity capital is the purchaser of new shares of common stock. But this is not the only source. For many corporations the most important source of ownership or equity capital is in the form of retained earnings, an internal source of funds.

Thus when we compute the cost of retained earnings, this takes us back to the point at which we began our discussion of the cost of common stock. The cost of retained earnings is equivalent to the rate of return on the firm's common stock. This is the opportunity cost. Thus we say the cost of common equity in the form of retained earnings is equal to the required rate of return on the firm's stock as shown as follows.

The cost of common equity in the form of retained earnings is equal to 12 percent. Please refer back to Table 1 in part 39 of this analysis and observe in column (1) that 12 percent is the value we have used for common equity. 

Cost of New Common Stock

Overview of Common Stock Costs

For those of you who are suffering from an overexposure to Ks in the computation of cost of common stock, let us boil down the information to the only two common stock formulas that we will be using in the rest of this analysis.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 318-320*

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