Page 309 - Corporate Finance PDF Final new link

NPP

BRILLIANT’S Cost of Capital 309

(ii) If floatation cost = ` 2, then;
20
K   20.41%
p
100 2
(iii) If the preference share is selling at a premium, say, ` 110:
20 20
K    18.52%
p
110 2 108

(iv) If the preference share is selling at a discount, say ` 90:
20 20
K    22.73%
p
90 2 88
Cost of Retained Earnings [aQ>oÝS> A{ZªJ H$s H$m°ñQ>
The cost of retained earnings is closely [aQ>oÝS> A{ZªJ H$s H$m°ñQ>, Bp³dQ>r eo¶g© H$s H$m°ñQ>
related to the cost of equity shares. If earnings go K{ZîR> ê$n go gå~pÝYV h¡& ¶{X A{ZªJ [aQ>oÝS> Zht
are not retained they will be paid out to the hmoVr h¡ V~ CÝh| {S>{dS>oÝS> Ho$ ê$n ‘| Bp³dQ>r eo¶ahmoëS>g©
equity shareholders as dividends. Retained H$mo {X¶m OmVm h¡& [aQ>oÝS> A{ZªJ H$mo àm¶: ZB© Bp³dQ>r Ho$
earnings are often looked on a fully subscribed
nyU©V: gãgH«$mBãS> Bí¶y Ho$ ê$n ‘| XoIm OmVm h¡, ³¶m|{H$
issue of new equity, since they increase the
shareholder's equity in the same way that a ¶o eo¶ahmoëS>g© H$s Bp³dQ>r H$mo Cgr àH$ma ~‹T>mVo h¡ {Og
new issue of equity share would. Therefore, the àH$ma Bp³dQ>r eo¶a Ho$ Z¶o Bí¶y& AV: [aQ>oÝS> A{Zª½g
cost of retained earnings must be viewed as H$s H$m°ñQ> H$mo {dÚ‘mZ Bp³dQ>r eo¶ahmoëS>g© Ho$ {bE
the opportunity cost of the foregone dividends nyd©{ZYm©[aV {S>{dS>oÝS²>g H$s Am°ßÀ¶y©{ZQ>r H$m°ñQ> Ho$ ê$n ‘|
to the existing equity shareholders. XoIZm Mm{hE&
If the firm is unable to earn as much on its ¶{X, H$moB© ’$‘© [añH$ Ho$ VwbZmË‘H$ ñVa na Aݶ
retained earnings as other firms with a ’$‘© go A{YH$ A{Zª½g [aQ>oÝS> H$aZo ‘| Ag‘W© ahVr h¡,
comparable level of risk, the shareholders will V~ eo¶ahmoëS>g© BZ A{Zª½g H$mo {S>{dS>oÝS> Ho$ ê$n ‘| àmßV
prefer to receive these earnings in the form of
dividends, so that they can invest in other firms. H$aZm Mmh|Jo Vm{H$ Cgo Xÿgar ’$‘© ‘| BÝdoñQ> H$a gHo$& O~
When the company retains earnings, it assumes H$moB© H§$nZr A{ZªJ [aQ>oZ H$aVr h¡ dh ¶o ‘mZVr h¡ {H$
that the shareholders can not earn as much on eo¶ahmoëS>g© Aݶ H$hr [aBÝdoñQ> H$aHo$ YZam{e Zht A{O©V
the money elsewhere through reinvestment. H$a gH$Vo h¡&
The cost of funds obtained by retained [aQ>oÝS> A{Zª½g Ûmam àmßV ’$ÊS²>g H$s H$m°ñQ> ’$‘© Ho$
earnings, can be defined as the rate of return,
Bp³dQ>r eo¶g© na eo¶ahmoëS>g© Ûmam Ano{jV [aQ>Z© aoQ> Ho$
shareholders require on the firm's equity
shares. ê$n ‘| n[a^m{fV {H$¶m Om gH$Vm h¡&
The value of an equity depends, ultimately {H$gr Bp³dQ>r H$s d¡ë¶y eo¶a na {X¶o J¶o {S>{dS>oÝS²>g
on the dividends paid on the share: na {Z^©a H$aVr h¡:

D 1 D 2
P  1  2  .....
o
1 K  r 1 K  r