Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internalRead more
Accumulated profit is the amount of profit left after the payment of dividends to the shareholders. It is also known as retained earnings. It is the profit that is not distributed as dividends to shareholders, hence called retained earnings. This accumulated profit is an important source of internal finance for a company. Accumulated profit or retained earnings can be ascertained using the following formula:
Accumulated profit = Opening balance of accumulated profit + Net Profit/Loss (loss being in the negative figure) – Dividend paid
Accumulated profit can be put to the following uses:
- To reinvest into the business in form of capital assets or working capital.
- To repay the debt of the company.
- To pay dividends in future.
- To set off the net loss made by the company.
Accumulated profit and reserves are often considered the same. But in substance, they are not. The reserves are actually part of the accumulated profit, but the converse is not true. They are created by transferring amounts from the accumulated profit. While reserves are created for purpose of strengthening the financial foundation of a firm, the accumulated profit’s main purpose is to make reinvest in the business to increase its growth.
The amount of accumulated profits depends upon the retention ratio and dividend payout ratio of a company. The retention ratio is the opposite of the dividend payout ratio.
The formula of dividend pay-out ratio = Dividend payable/Net Income
And retention ratio = 1 – (Dividend payable/Net Income)
If the retention ratio is more than the dividend payout ratio, the accumulated profit remains positive.
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Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders. Therefore the cost of retained earnings is similar to theRead more
Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders.
Therefore the cost of retained earnings is similar to the cost of equity without tax and flotation cost. Hence, it can be calculated as
Kr = Ke (1 – t) (1 – f),
Kr = Cost of retained earnings
Ke = Cost of equity
t = tax rate
f = flotation cost
Here, flotation cost means the cost of issuing shares.
EXAMPLE
If cost of equity of a company was 10%, tax rate was 30% and flotation cost was 5%, then
cost of retained earnings = 10% x (1 – 0.30)(1 – 0.05) = 6.65%.
From the above example and formula, it is clear that the cost of retained earnings would always be less than or equal to the cost of equity since retained earnings do not involve flotation costs or tax.
A company usually acquires funds from various sources of finance rather than a single source. Therefore the cost of capital of the company will be the weighted average cost of capital (WACC) of each individual source of finance. The cost of retained earnings is thus an important factor in calculating the overall cost of capital.
Another important factor of WACC is the cost of equity. The cost of equity is sometimes interchanged with the cost of retained earnings. However, they are not the same.
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