Cost of retained earnings vs cost of equity?

[kmj2318]

I’ve seen in some practice problems (forget which ones exactly) that they’ll give you both cost of equity and cost of retained earnings, and you’re supposed to use cost of retained earnings for “cost of equity” for things such as WACC, discounting, etc. I’m pretty sure the difference is that cost of equity is the cost that it would be if issuing new equity. If so, why not use the marginal figure? What’s the reason for using cost of retained earnings instead of cost of equity?

 

[CarloRoco]

ill put it this way… if a company has a development project.. it can be financed with either debt or equity OR earnings it recieved from operations. each one has a cost to them. WACC by definition is simply the cost of raising capital… buuuut for retained earnings we do not raise capital for that because it is readily available albeit limited. its cost is essentially the opportunity cost.. the gain that may be acheive if we use it elsewhere. orrr some required return that shareholders are asking for this scpefic project… lots of things.

 

[kmj2318]

CarloRoco wrote:
ill put it this way… if a company has a development project.. it can be financed with either debt or equity OR earnings it recieved from operations. each one has a cost to them. WACC by definition is simply the cost of raising capital… buuuut for retained earnings we do not raise capital for that because it is readily available albeit limited. its cost is essentially the opportunity cost.. the gain that may be acheive if we use it elsewhere. orrr some required return that shareholders are asking for this scpefic project… lots of things.

Ahh, i got ya. Makes a lot of sense now, especially since it was from a question regarding residual dividend policy. Thanks

 

[bloodline]

CarloRoco wrote:
ill put it this way… if a company has a development project.. it can be financed with either debt or equity OR earnings it recieved from operations. each one has a cost to them. WACC by definition is simply the cost of raising capital… buuuut for retained earnings we do not raise capital for that because it is readily available albeit limited. its cost is essentially the opportunity cost.. the gain that may be acheive if we use it elsewhere. orrr some required return that shareholders are asking for this scpefic project… lots of things.

I’m am not sure i understand this view. Earnings is a part of equity, both of which costs, are inclusive in the costs of equity. I don’t think there should ever be a seperate item called opportunity costs of retained earnings.

 

[kobi]

It’s very confusing. If we are not given any specific guidelines, we can not determine ourselves which one to use to calculate WACC or simply when discounting cash flows.

 

[kobi]

bloodline wrote:

CarloRoco wrote:
ill put it this way… if a company has a development project.. it can be financed with either debt or equity OR earnings it recieved from operations. each one has a cost to them. WACC by definition is simply the cost of raising capital… buuuut for retained earnings we do not raise capital for that because it is readily available albeit limited. its cost is essentially the opportunity cost.. the gain that may be acheive if we use it elsewhere. orrr some required return that shareholders are asking for this scpefic project… lots of things.

I’m am not sure i understand this view. Earnings is a part of equity, both of which costs, are inclusive in the costs of equity. I don’t think there should ever be a seperate item called opportunity costs of retained earnings.

Agree with bloodline!

 

[KevPei]

hmm.. seems like i’m missing knowledge. what reading is this concept from?

 

[CarloRoco]

this is simply on a “good to know basis”. you need not know it for the exam im pretty sure
the same way it gets more expensive to raise additional debt (lack of supply or more risk) raising additional capital has its costs as opposed to capital readily available.
personally i dont think it will be on the test.. i dont think i even see it in cfa 2 curriculum.. i was just reconciling the concept of cost of equity and cost of retained earnings, because it does exist.

 

[bloodline]

Thanks CarloRoco. I also don’t think it will be on the test, but it still doesn’t make much intuitive sense to me.