Impacts of Retained Earnings on Shareholders Investment Decisions

  

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Table of contents

What are retained earnings?

Reasons for retained earnings

Dividend and how it impacts retained earnings

How retained earnings impact on shareholders investment decisions

Before we talk about how Retained Earnings impact on shareholders investment decisions, let’s know what Retained Earnings mean, the reason for Retained Earnings and how to calculate it.

What Are Retained Earnings?

Retained Earnings are earnings or profits made by a business organization in a given period which have been retained by the organization rather than paid out as dividends to shareholders. It is therefore the sum of such earnings retained to date. Its size depends on profits, rate of taxation, dividends paid, other statutory deductions from profits as well as the organization’s policy.

Reasons For Retained Earnings

Retained Earnings provide capital that can be used for expansion of business or as working capital. This source of fund is cheaper and surer than borrowed funds. When a firm requires fund for business project the management may consider retaining and reinvesting some portion of the profits that were supposed to be paid out to shareholders in form of dividends rather than sourcing for funds outside. This reduces firm’s cost of capital. Although there’s usually opportunity cost associated with retained earnings, it’s far much cheaper than cost of borrowing or floatation cost involved in selling new stock in the stock market.

Retained Earnings Formula

Retained Earnings Formula is given as:

RE = beginning period RE + net profit or loss – cash dividend – stock  dividend

Beginning Period Retained Earnings

It is balance of retained earnings brought forward from the balance sheet of the previous accounting year into the next accounting year. It is reported in a balance sheet as cumulative income from the previous years (including the current year),  minus paid dividends. 

Net Profit or Loss And How It Impacts Retained Earnings

It means surplus or deficit in revenue after subtracting costs. The costs may include cost of goods sold, depreciation, other operating costs, impairment, stock-based compensation etc. When the revenue is surplus, it means net profit, but when it’s deficit, it means loss. Any change in net income directly affects Retained Earnings 

Dividend And How It Impacts Retained Earnings


Dividend is a return paid to a company’s shareholders as a reward for their investment in the company’s business. Dividends can be paid in cash or in stock. Dividend payment constitute cash outflow. A higher dividend rate means less retained earnings and consequently,  a slower growth rate in earnings and stock prices. 


Read also: Top Business Growth Opportunities


How Retained Earnings Impact On Shareholders Investment Decisions 


Retained Earnings can have so many impacts on a firm’s shareholders investment decision making. Some of these impacts are discussed bellow:


Retained Earnings deny shareholders the opportunity to invest in alternative investments: Retained earnings impact on the decision of the shareholders on investing in other business opportunities. If the retained earnings were paid out to the shareholders in form of dividends, such funds could be invested by the shareholders in other stocks, bonds, real estate, etc. Shareholders would not be able to invest in the alternative investment. Therefore, such funds should not be considered as free by the firm management because opportunity cost is involved. The expected rate of return on these alternative investments is the opportunity cost. 


Cost of Retained Earnings 


Funds are retained in the organization for investment, they represent the source of equity capital to the organization that is being supplied internally by the current shareholders. There is cost associated with it. The assumption is that shareholders could at least earn an equivalent return to that provided by their present investment in the firm on an equal risk basis. 

The cost of common equity in the form of retained earnings is therefore equal to the required rate of return on the firm’s stock.

Formula For Calculating Cost Of Retained Earnings 

Ke = Di/Po + g

Where:

Ke = Cost of common equity in the form of retained earnings 

Di = Dividend at the end of the first year 

Po = Current price of the stock

g = Constant growth rate in dividend


Worked Example 

If a firm’s paid out dividend in the first year was $1, current stock price is $20 with constant growth rate in dividend of 10%, what is the cost of common equity in the form of retained earnings? 

Solution:

Ke = Di/Po + g = $1/$20 +10%

                         = 5% + 10% = 15%

The cost of common equity in the form of retained earnings is equal to 15%. It is the minimum rate of return on the retained earnings the management must earn to justify retaining and reinvesting them into the business instead of paying them out to shareholders in form of dividends. 


Shareholders who prefer regular income from their investments may decide to divest themselves off their equity shares in the company: Anytime a firm declares net profits, shareholders expect some returns in form of dividend as a reward for investing in the business. When these profits are retained in stead of being shared, it will impact on the decisions of the shareholders. Shareholders who prefer regular returns may wish to sell off their shares in the company for alternative investments which they think can offer them regular returns.


Retained Earnings indicate growth-oriented company management: When company management decides to retain earnings and reinvest them in the business for growth, expansion, it indicates that the management are growth-focused. And shareholders who believe in the capacities of the management may welcome the idea of retaining the earnings and reinvesting them with hope of getting higher income in the future. 


Shareholders can use “Retained Earnings To Market Value” in their investment decision making: Retained Earnings To Market Value assesses the changes in stock price against the net earnings retained by the company. The value of the undeclared dividends (retained earnings)  must be balanced against its opportunity cost. When it’s positive, the shareholders would accept the earnings that were supposed to be shared to them in form of dividends be retained by the management, and forego any other investment opportunities. When it’s otherwise, the shareholders are likely to disagree with the management and demand that their earnings be shared.

NOTE: Management does not unilaterally decide on whether or not to retain earnings. The management must do such in consultation with the shareholders.


 • Retained Earnings may not present  enough insight for investment decision: Sometimes, the figures of retained earnings over a period of time do not give enough insight to the shareholders to make investment decision as regards how much the retained earnings have generated compared to any investment alternatives.


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