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BRILLIANT’S Cost of Capital 311

share price will fall, if it earns more, this will CgH$s eo¶g© àmBg {JaoJr, VWm ¶{X dh K go A{YH$ AZ©
rise. H$aoJr V~ àmBg ~‹T>oJr&
Based on the fact that individuals are taxed Bg ’¡$³Q> Ho$ AmYma na {H$ {S>{dS>oÝS> H$a ¶mo½¶ hmoVm
on dividends and that they must pay brokerage h¡ VWm CÝh| AnZo ’$ÊS²>g H$mo [aBÝdoñQ> H$aZo Ho$ {bE
fees to reinvest their funds, the firms need not ~«moH$aoO ’$ÊS> XoZm n‹S>Vm h¡, ’$‘© Ho$ {bE [aQ>oÝS> A{Zª½g
obtain higher return on retained earnings as
na A{YH$ [aQ>Z© àmßV H$aZm Amdí¶H$ Zht hmoVm h¡ ³¶m|{H$
they must obtain on equity capital. A firm do Bp³dQ>r H¡${nQ>b na [aQ>Z© àmßV H$a gH$Vo h¢& EH$ ’$‘©
obviously does and the owners could do for
themselves. Hence, in determining the cost of {ZpíMV hr Eogm H$aVr h¡ Am¡a AmoZg© ^r ñd¶§ Ho$ {bE Eogm
retained earnings, the firm may discount the H$a gH$Vo h¢& AV: [aQ>oÝS> A{ZªJ H$s H$m°ñQ> H$mo {ZYm©[aV
investor's tax and brokerage fees. The result is H$aZo Ho$ {bE, ’$‘© BÝdoñQ>a Ho$ Q>¡³g VWm ~«moH$aoO ’$sg ‘|
the following equation which provides the cost {S>ñH$mC§Q> H$a gH$Vr h¡& {ZåZ{b{IV ’$m°‘y©bo go [aQ>oÝS>
of retained earnings. A{Zª½g H$s H$m°ñQ> kmV H$s Om gH$Vr h¡:
K = K (1 – t) (1 – B)
r e
Where,
K = the cost of retained earnings K = the cost of equity capital
r
e
t = the owner's marginal-tax rate B = the average brokerage fee.
But, the use of equation requires that the {H$ÝVw Bg ’$m°‘y©bo Ho$ Cn¶moJ Ho$ {bE ¶h Amdí¶H$ h¡
financial manager must be able to estimate the {H$ ’$m¶Z|{e¶b ‘¡ZoOa AmoZg© H$s ‘m{O©Zb Q>¡³g aoQ> VWm
owner's marginal tax rate and brokerage fees. ~«moH$aoO ’$sg H$mo Am§H${bV H$aZo ‘| g‘W© hmo&
Illustration 4.1.2
Standard Products has a cost of equity capital of 20%. While the owner's marginal tax rates
vary among industries due to different types of investors attracted, approximate value for
Standard Products of t and B are established at 40% and 3% respectively. Using the average value
for the owner's marginal tax, rates and brokerage fees. Determine the cost of retained earnings for
Standard Products.
ñQ>¢S>S>© àmoS>³Q> H$s 20% Bp³dQ>r H¡${nQ>b H$s bmJV hmoVr h¡& O~{H$ AmH${f©V {H$¶o J¶o {ZdoeH$m| Ho$ {d{^ÝZ àH$mam|
Ho$ H$maU CÚmoJm| Ho$ ~rM Am°Za H$s ‘m{O©Zb Q>¡³g aoQ²>g ~XbVr h¡, t VWm B Ho$ ñQ>¢S>S>© àmoS>³Q²>g Ho$ {bE AZw‘m{ZV ‘yë¶
H«$‘e… 40% VWm 3% na ñWm{nV {H$¶o J¶o h¢& Am°Za H$m ‘m{O©Zb Q>¡³g, aoQ²>g VWm ~«moH$aoO ’$sg Ho$ {bE Am¡gV ‘yë¶
H$m Cn¶moJ H$a|& ñQ>¢S>S>© àmoS>³Q²>g Ho$ {bE [aQ>¢S> A{Zª½g H$s bmJV {ZYm©[aV H$s{OE&
Solution:

Employ equation: K = K (1 – t) (1 – B) = 0.20 (1 – 0.4) (1 – 0.03)
r e
= 0.20 (0.60) (0.97) = 0.1164
The cost of retained earnings is 11.64%.

Cost of Equity Bp³dQ>r H$s H$m°ñQ>
The cost of equity can be generally stated Bp³dQ>r H$s H$m°ñQ> gm‘mݶV: Cg aoQ> H$mo H$hm Om
as the rate at which investors discount the gH$Vm h¡ {Og na BÝdoñQ>g© H$mo ’$‘© ‘| AmoZa{en BÝQ>aoñQ>