Cost of Equity vs Cost of Retained Earnings: Difference and Comparison

An analyst should determine the paths that lead the company to the next stage as a benefit and a reputation. It means the production of income if you claim benefit. Companies are looking for equity funding or retained earnings.

Both words are highly comprehensive.

Key Takeaways

  1. Cost of equity refers to the minimum rate of return a company must offer its shareholders to compensate them for the risk of investing in the company. In contrast, the cost of retained earnings refers to the opportunity cost of using them to finance projects instead of distributing them to shareholders as dividends.
  2. The cost of equity is calculated based on the company’s cost of capital and the risk premium associated with its equity. In contrast, the cost of retained earnings is calculated based on the return shareholders could have earned if the company had distributed the earnings as dividends.
  3. The cost of equity determines the cost of capital for equity financing. In contrast, the cost of retained earnings is used to evaluate the opportunity cost for financing projects.

Cost of Equity vs Cost of Retained Earnings

Cost of Equity (CoE) refers to the return an investor expects for owning a share of a company’s stock. CoE is calculated by considering the risk associated with investing in a company and adjusting the expected return accordingly. Cost of Retained Earnings (CoRE) refers to using internal funds generated from past profits instead of borrowing or issuing new shares to finance a company’s growth. CoRE reflects the opportunity cost of not paying dividends to shareholders and retaining earnings to reinvest in the business.

Cost of Equity vs Cost of Retained Earnings
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The cost of equity ensures that equity lenders have to return the required amount. There is also a way to determine the worth of equity costs. Models are used, and the most popular model is the pricing model of capital assets (CAPM).

The cost of retained earnings is the expenses a company has internally generated.

The cost of retained earnings values thus estimates the return investors hope to gain from their equity investments in the business derived from a valuation model of capital assets (CAPM).

Comparison Table

Parameters of ComparisonCost of EquityCost of Retained Earnings
DefinitionThe cost of equity is the required rate of return for equity owners, or we may claim the equities owned by shareholders.The part of revenues not paid but maintained and used in the company by shareholders has retained income.
Formular(a) = r(f) + ß(a) [ r(m) – r(f) RE = Beginning Period RE + Net Income/Loss – Cash Dividends – Stock Dividends
Rate based on returnThe cost of equity is essentially a return rate requested by a company’s owners.Shareholders are entitled to a stable return rate, even though the business is not profitable enough.
Base of interestThere’s no paying interest at any moment.Retained revenues do not allow shareholders to profit fully from the company’s revenues. This leads to unhappiness among shareholders and a negative influence on the share’s market value.
FoundationThe equity costs are determined using a proposed formula, namely CAPM.The rate of retained profits approximates the return investors hope to make on the company’s equity investment and can be extracted from the capital asset pricing model (CAPM).

What is Cost of Equity?

In the end, the returns generated are significant. Not only is it a must, but it also leads to the next stage of inspiration. Equity costs are also associated with sales production.

This means that a corporation or management has to determine if an investment complies with the capital gain. It is simply the portion earned by a company’s owners.

A business’s equity cost reflects the services or something worthwhile that markets ask to own property in return for ownership risks.

Various models are used for value calculation, but the dividend capitalization and capital assets pricing model (CAPM) is dominant.

The formula covers the following year’s dividend per share, the new stock price valuation, and the dividend increase. It is a relation between two terms in the group or the lender.

There are two ways to raise money from a corporation. Mode of Equity or debt There is no requirement to repay equity, but the benefits associated with taxation that are not here cost more than the share capital.

cost of equity

What are Retained Earnings?

The retained income (RE) is the cumulative share of a company’s earnings not paid to owners as dividends but reserved for reinvestment.

These funds are used to buy or discharge debt liabilities for working capital and fixed assets (capital expenditures). After every accounting year, recovered earnings shall be listed on the balance sheet in the equity column of the shareholder.

The RE balance is applied to or lowered by a net loss to measure the RE balance, and dividend payments are subtracted.

A summarized report is still kept, containing modifications to the RE for a specific duration, called the declaration of retained profit.

The retained profit is an important relationship between the statement of revenue and the balance sheet, as reported on an equity basis, which links the two accounts.

The aim of maintaining such income may vary and involves the purchase of new machinery and equipment, research and development expenditure, or other practices which could theoretically lead to growth for the business.

This reinvestment in the business is intended in the future to generate still more income.

retained earnings

Main Differences Between Cost of Equity and Cost of Retained Earnings 

  1. The equity or loan holders are accountable for retained profits, while the lenders are responsible for their equity costs.
  2. The cost of equity is all about debt, banks, and loans; thus, it is payable, while retained earnings have little to do with taxation.
  3. The cost of retained earnings is the rate requested by bondholders, while the cost of equity is the rate of return on the investment the owners require.
  4. Retained earnings don’t have to be repaid but are more than debt in general, whereas costs of equity are higher than debt; they yield a high return premium.
  5. Considering the formula, the cost of equity concerns the dividend capitalization model for the valuation of capital assets. Still, the costs of retained earnings are both pre-tax rates and tax adjustments.
References
  1. https://search.proquest.com/openview/b14670f2cec7ae6df7cb39d734bbf844/1?pq-origsite=gscholar&cbl=35192
  2. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1911-3846.2011.01088.x

Last Updated : 13 July, 2023

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