Difference Between Cost of Equity and Cost of Retained Earnings

Introduction

It is essential for any person who wants to start a business to know about the different sources of finance from which money can be raised so that choice of the most appropriate source can be made. Business is concerned with the production as well as distribution of goods and services for the satisfaction of the needs of society. For carrying out different activities, business requires money. Finance is thus called the lifeblood of any business. The requirement of funds by a company to carry out its activities is called business finance. A business cannot function unless it has access to adequate funds. A clear assessment of the financial requirements as well as the identification of different sources of finance is thus a significant aspect of running a business organization.

Owner’s funds mean funds that are provided by the owners of an enterprise; apart from capital, it even includes profits reinvested in the business. The owner's money remains invested in the industry for a long duration, and it is not mandated to be refunded during the life of the company. Issue of equity shares and financing through retained earnings are the two essential sources from which the owner's funds can be obtained. An informed decision must be taken to choose between the two sources of owners' funds by analyzing the cost of equity and cost of retained earnings.

Cost of Equity vs Cost of Retained Earnings

The critical difference between the cost of equity and the cost of retained earnings is that cost of equity is supported by the company's debt holders. In contrast, the cost of retained earnings is collected and accepted by the company's owners, who are also known as the company's shareholders. Cost of equity is the required rate of return for equity owners or the equities owned by shareholders. The part of the revenue that was not paid but maintained and used in the company by shareholders is retained income. The shareholders decide to maintain the profits generated by the business within the business and therefore forego a part of the dividends that they are entitled to. This is known as the cost of retained earnings. The cost of equity is a return requested by the company's owners, while the cost of retained earnings is determined at a fixed rate even if the company has not made significant profits. Equity and retained earnings are two types of raising finance through owners' funds. They have their own merits and demerits that must be analyzed before deciding about the choice of funds.

Difference Between Cost of Equity and Cost of Retained Earnings in Tabular Form

Parameters of Comparison	Cost of Equity	Cost of Retained Earnings
Definition	Cost of equity is defined as the required rate of return for equity owners or the equities owned by shareholders.	The shareholders decide to retain the profits generated by the business within the business and therefore forego a part of the dividends that they are entitled to. This is known as the cost of retained earnings.
Methods	There are two methods to calculate the cost of equity- the dividend capitalization method and the capital asset pricing model.	There is only one method to calculate the cost of retained earnings
Rate of return	The cost of equity is decided according to the requests of the shareholders.	The cost of retained earnings is a standard rate even if the company fails to be profitable in some years.
Shareholders’ preference	Shareholders receive the Dividend on their shares in case of equity.	Shareholders forego a part of the Dividend that they are entitled to receive. This may lead to unhappiness on the part of shareholders.
Higher/lower cost	The cost of equity tends to be higher than the cost of retained earnings as the issue of equity necessitates mandatory and non-mandatory expenses like an issue of prospectus, the appointment of underwriters and stockbrokers, floatation costs involved, etc.	The cost of retained earnings is lesser than the cost of equity as retained earnings do not involve expenses like the cost of equity.
Payment of Dividend	Cost of equity involves the cost involved in the payment of Dividend to shareholders (both equity and preference shareholders)	The cost of retained earnings does not involve the payment of any dividends.
Additional costs	Cost of equity includes additional costs involved as the selling price of shares may be lower than the actual market price of the shares.	Retained earnings do not involve any such costs. Hence the cost of retained earnings is exempted from such expenses.

What is the Cost of Equity?

Equity shares are the most vital source of raising long-term capital for any company. This is because equity shares represent the ownership of a company. Equity shareholders are paid based on the earnings of the company. They are known as 'residual owners' of the company since they receive only what is left after all claims on the company have been settled. They enjoy the reward and also bear the risk of ownership. But, their liability is limited to the extent of capital contributed by them to the company. Through their right to vote, the shareholders have a right to participate in the decision-making of the company.

The cost of equity is known as the return that a company needs to decide if an investment meets capital return requirements. Firms generally use it as a capital budgeting threshold to determine the required rate of return. The cost of equity of a firm represents the compensation that the market demands in exchange for owning the asset/investment and for also bearing the risk of ownership. The formula for the cost of equity is the dividend capitalization model and the capital asset pricing model.

Formula for calculating the cost of equity using the dividend capitalization method:

This model can be used by a company to calculate the cost of equity only if the company pays a dividend to its shareholders.

Cost of equity (%) = Dividend per share (for next year)/Current market value of stock + Growth rate of Dividend

The formula for calculating the cost of equity of a company using the Capital asset pricing model:

This method describes the relationship between systematic risk and expected return for assets. (Particularly stocks of the company). The aim of this method is to evaluate whether a stock is valued when its risk, as well as time value of money, are compared with its expected return.

Expected rate of return (%) = Risk-free rate + beta of investment * market risk premium

1. The beta of an investment (potential) is a measure of the amount of risk the acquisition will add to a portfolio that resembles the market. If a stock is considered riskier than the market, it will have a beta greater than one. If a store has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.
2. A market risk premium is a return expected from the market above the risk-free rate.
3. The risk-free rate is defined as the theoretical rate of return on investment with zero risk. It is the benchmark to measure other assets that include an element of risk.

Why is the cost of equity more than the cost of retained earnings?

1. Procurement costs- Equity is raised by a company by inviting the public to subscribe to its shares. This involves high floatation costs like an issue of prospectus, the appointment of underwriters, stockbroker, merchant bankers etc. However, retained earnings do not include any such costs. This is because they are the profits that the company has earned and retained for future operations and financial requirements.
2. Maintenance costs- Equity requires Dividends to be paid to shareholders at prefixed times during the year. Retained earnings, on the other hand, do not involve any such obligations. However, it is not compulsory for a company to pay dividends to its shareholders every year.
3. Other costs- The selling price of shares may be lesser than their market price.
4. Dilution of control- The more equity is issued, the more members there are that enjoy voting rights regarding firm decisions. Although this may not have a direct financial impact on the company, a wrong unanimous decision on the part of shareholders may cause future turbulence for the company.

What is the Cost of Retained Earnings?

A company usually does not distribute all its earnings to shareholders as dividends. A portion of the total earnings may be retained in the business for use in the future. This is known as retained earnings.

Merits of retained earnings:

1. Retained earnings are considered to be a permanent source of funds that are available to any organi
2. zation. They do not involve any sort of explicit costs (in the form of interest, Dividend, or floatation cost.)
3. Since the funds are generated internally, there is greater degree of operational freedom and flexibility.
4. It enhances the capacity of the business to absorb unexpected losses
5. It may lead to an increase in the market price of equity shares of a company.

Limitations of retained earnings:

1. Excessive ploughing back of profits may cause dissatisfaction amongst the existing shareholders as they would be entitled to get lower dividends.
2. However, it is an uncertain source of funds as the profits of a business fluctuate.
3. Since the opportunity cost involved with these funds is not recognized by many firms, it may lead to sub-optimal use of the funds.

Formula to calculate the cost of retained earnings:

Retained earnings= Beginning Period Retained earnings + Net Income/Loss – Cash Dividends – Stock Dividends

Main Differences Between Cost of Equity and Cost of Retained Earnings In Points

1. The cost of equity is defined as the required rate of return for equity owners or the equities owned by shareholders. The shareholders decide to retain the profits generated by the business within the business and therefore forego a part of the dividends that they are entitled to. This is known as the cost of retained earnings.
2. Two methods to calculate cost of equity are the dividend capitalization method and the capital asset pricing model method. There is only one method to calculate the cost of retained earnings.
3. The rate of return in the case of the cost of equity is determined at a rate requested by the shareholders, while the cost of retained earnings is maintained at a pre-determined rate.
4. Shareholders receive Dividends in case of equity and do not receive dividends in case of retained earnings.
5. The cost of equity tends to be higher than the cost of retained earnings as the issue of equity necessitates mandatory and non-mandatory expenses like an issue of prospectus, appointment of underwriters and stockbrokers, floatation costs involved, etc. Retained earnings do not involve any expenses like the cost of equity.
6. Cost of equity involves the cost of payment of Dividends to shareholders (both equity and preference shareholders). The cost of retained earnings does not involve the payment of dividends to shareholders.
7. Issue of equity shares dilutes control in a company. This is because equity shareholders enjoy voting rights. This problem is not faced by existing shareholders if they opt to raise funds for retained earnings. Any wrong decision by the shareholders may result in future complications for the company.
8. Cost of equity involves additional costs involved as the selling price of shares may be lower than the actual market price of the shares. Retained earnings do not involve any such costs. Thus, the cost of retained earnings is exempt from such costs.

Conclusion

Two methods of raising business finance through owners’ funds are retained earnings and equity. Retained earnings consist of the profits retained by the firm from its previous years. Equity includes both equity share capital and preference share capital. This article has attempted to explain the differences between the costs involved with both the sources of fiancé over various parameters like which cost is higher, methods to calculate the two costs, rate of return, and shareholders preference. This article has further explained the concept of cost of equity and its formula. It has also covered the concept of retained earnings in-depth and explained why  cost of equity is usually more than the cost of retained earnings. The two sources of business finance have their own merits and demerits that need to be carefully analyzed before making a choice about the source of fiancé most suitable for one's enterprise.

References

1. www.investopedia.com
2. Class 12 NCERT Business studies textbook