opportunity cost of retained earnings is the rate of return that can be earned

# Opportunity cost of retained earnings is the rate of

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opportunity cost of retained earnings is the rate of return that can be earned by investing the funds in another enterprise by the firm. Thus, according to this approach, the cost of retained earnings is simply the return on direct investment of funds by the firm and not what the shareholders are able to obtain on their investments. The approach represents an economically justifiable opportunity cost that can be applied consistently. Moreover, the need for determining the 43 marginal tax rate for investors will not arise in case the approach is follows. The "External Yield Criterion", suggested above, has not yet been universally accepted. In the absence of a universally acceptable and practically feasible method for determining separately the cost of retained earnings, many accountants calculate the cost of retained earnings on the same pattern as that of equity shares. Moreover, when the cost of funds raised by equity shares, the need for determining the separate cost for retained earnings does not at all arise. Some calculate it on the Dividend Payout Basis. Weighted average cost of capital After calculating the cost of each component of capital, the average cost of capital is generally calculated on the basis of weighted average method. This may also be termed as overall cost of capital. The computation of the weighted average cost of capital involves the following steps: 1. Calculation of the cost of each specific source of funds: This involves the determination of the cost of debt, equity capital, preference capital, etc., as explained before. This can be done either on "before tax" basis or "after tax" basis. However, it will be more appropriate to measure the cost of capital on "after tax 44 basis". This is because the return to the shareholders is an important figure in determining the cost of capital and they can get dividends only after the taxes have been paid. 2. Assigning weights to specific costs : This involves determination of the proportion of each source of funds in the total capital structure of the company. This may be done according to any of the following method. (a) Marginal weights method: In case of this method weights are assigned to each source of funds, in the proportion of financial inputs the firm intends to employ. The method is based on the logic that our concern is with the new or incremental capital and not with capital raised in the past. In case the weights are applied in a ratio different than the ratio in which the new capital is to be raised, the weighted average cost of capital so calculated may be different from the actual cost of capital. This may lead to wrong capital investment decisions. However, the method of marginal weighting suffers from one major limitation. It does not consider the long-term implications of the firm's current financing. A firm should give due attention to long-term implications while designing the firm's financing strategy. For example, a firm may accept a project giving an aftertax return of 6% because it intends to raise the funds required by issue of debentures having an after-tax cost of 5%. In case next year the firm  #### You've reached the end of your free preview.

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• Fall '16
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