- Cost of retained earnings
Retained earnings have implicit costs. In operational terms, there is an opportunity cost
of retentions. This in turn, is equivalent to the plausible income which could have been
earned by equity shareholders themselves, if profits had been distributed among them
instead of being retained by corporate firms.
Viewed from another perspective (strictly speaking) these are the funds belonging to the
equity holders; they in a way, represent unissued equity on share capital. Therefore, their
costs can be regarded as equivalent to the cost of existing equity capital. However, in
effect, the cost of retained earnings taxes (say withholding taxes) and involves transfer
costs.
- Weighted average cost of capital
Computation of weighted average cost of capital/overall cost of capital (k 0 ) is now an
easy exercise. It is the weighted arithmetic mean of the costs of individual long-term
sources of finance. Its computation is
K 0 = ke+ We + kp+ Wp + kd + Wd + kr+ Wr
Where We = weight of equity (i.e. the relative share of equity share capital to the total
Long-term funds of the corporate enterprise)
Likewise, Wp refers to the weight of preference share capital, Wd represents weight of
debt and Wr indicates weight of retained earnings.
These weights may be based on book value or market value. Theoretically, market value
weights are considered superior as the costs of specific sources of finance are computed
using the prevailing market price. However, in practice, there are practical difficulties in
computing market value (say of retained earnings). Besides, market values are likely to
fluctuate widely. No such problem is faced with book value weights.
The basic principle of finance theory to determine the cost of capital of investment
projects undertaken at the level of foreign subsidiaries is to be applied, i.e., to take into
account the origin of the funds that finance the subsidiary and the risk involved in the
investment project.
If the investment in the subsidiary has the same level of risk as that of the group as a
whole and the total finances are provided by the parent company, the cost of capital to be
applied by subsidiaries is the same as that of the parent.
If the investment is partly financed by the parent company and partly by local
borrowings, the weighted average cost of funds of each of the two sources would
constitute the appropriate cost of capital. It may be worth mentioning capital and