Retained earnings

  • Retained earnings have an opportunity cost, which is equal to the cost of equity.
  • The cost of retained earnings can thus be found in the same way as the cost of equity.
  • It is a mistake to see retained earnings as a free source of finance.

Preference shares

  • The cost of preference shares can be found by dividing the preference dividend by the ex div market price:

Kps = cost of preference shares

P0 = current ex div preference share price

Dp = preference dividend

Irredeemable bonds

  • Like preference shares, bonds involve a constant annual payment in perpetuity.

Kd = cost of debt

I = annual interest payment

P0 = current ex interest market price

Note that interest is tax-deductible.

Irredeemable bonds

Calculating the cost of irredeemable bonds:

  • 10% irredeemable bonds
  • Ex interest market price: £72
  • Corporation tax: 30%
  • Kid (before tax) = 10/72 = 13.9%
  • Kid (after tax) = 13.9 x (1 – 0.3) = 9.7%

Redeemable bonds

  • Redeemable bonds involve several fixed interest payments plus redemption value

I = interest payment

RV = redemption value or principal

Kd = cost of debt capital

n = number of years to maturity

CT = corporation tax rate

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