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In this blog, we have discussed the cost of retained earnings and the cost of new equity, two important concepts in corporate finance. We have seen how to calculate them using different methods, and how to compare them to determine the optimal capital structure for a firm. In this section, we will summarize the main takeaways and implications of our analysis, and provide some recommendations for managers and investors. Here are some points to consider:
1. The cost of retained earnings is the opportunity cost of reinvesting the earnings back into the firm, instead of paying them out as dividends to shareholders. It is equal to the required rate of return that shareholders expect from the firm, based on its risk and growth prospects. The cost of retained earnings can be estimated using the dividend growth model, the capital asset pricing model, or the bond yield plus risk premium approach.
2. The cost of new equity is the cost of issuing new shares to raise external capital. It is higher than the cost of retained earnings, because it includes the flotation costs, which are the fees and expenses associated with the issuance process. The cost of new equity can be estimated by adding the flotation costs to the cost of retained earnings, or by using the modified dividend growth model.
3. The cost of retained earnings and the cost of new equity are both affected by various factors, such as the dividend policy, the growth rate, the risk level, the market conditions, and the tax rate. Managers and investors should be aware of these factors and how they influence the cost of capital for the firm.
4. The cost of retained earnings and the cost of new equity can be used to compare different financing options for the firm. Generally, the firm should prefer the option that minimizes its weighted average cost of capital (WACC), which is the average cost of all sources of capital, weighted by their proportions in the capital structure. The WACC reflects the overall risk and return of the firm, and it is used as the discount rate for evaluating the net present value (NPV) of investment projects.
5. The optimal capital structure for the firm is the one that maximizes its value, which is the sum of the present value of its expected future cash flows. The optimal capital structure depends on the trade-off between the benefits and costs of debt and equity financing. The benefits of debt financing include the tax shield, which is the reduction in taxable income due to the interest payments, and the discipline effect, which is the pressure to perform well and avoid bankruptcy. The costs of debt financing include the financial distress costs, which are the direct and indirect costs of default or bankruptcy, and the agency costs, which are the conflicts of interest between the debt holders and the equity holders. The benefits and costs of equity financing are the opposite of those of debt financing.
6. An example of how to use the cost of retained earnings and the cost of new equity to compare different financing options is the following. Suppose a firm has a current capital structure of 60% debt and 40% equity, and it needs to raise $100 million for a new project. The firm can either use retained earnings, issue new equity, or issue new debt. The cost of retained earnings is 12%, the cost of new equity is 15%, the cost of new debt is 8%, and the tax rate is 30%. The WACC for each option is calculated as follows:
- Option 1: Use retained earnings. The WACC is 12% x 0.4 + 8% x 0.6 x (1 - 0.3) = 7.44%.
- Option 2: Issue new equity. The WACC is 15% x 0.4 + 8% x 0.6 x (1 - 0.3) = 8.64%.
- Option 3: Issue new debt. The WACC is 12% x 0.4 + 8% x 0.6 x (1 - 0.3) x (1 - 0.1) = 7.08%, where 0.1 is the flotation cost as a percentage of the new debt.
The firm should choose the option that has the lowest WACC, which is option 3, issue new debt. This option will maximize the NPV of the project and the value of the firm. However, the firm should also consider the impact of the new debt on its risk and leverage ratios, and whether it can maintain its target credit rating and debt covenant. If the new debt increases the risk and leverage too much, the firm may prefer to use retained earnings or new equity instead.