CIMA BA1 Syllabus B. Microeconomic And Organisational Context Of Business - Returns To Shareholder Investment - Notes ^{7 / 13}

Assessing if return is acceptable

The return expected by shareholders is referred to as the Cost of equity 

This can be used to assess whether the profit that has been achieved is acceptable to shareholders.

Illustration

Cow Co has the following results

Cow Co has $ 100 million of equity capital and $ 200 million of retained earnings (including the $100 million from the current year as shown above).

Cow Co's shareholders expect a return of 10% (Cost of Equity).

Required
Assess whether Cow Co is producing an adequate short-term return to shareholders.

Solution
Profit after tax of $126m less $ 20m preference dividend leaves $106m for ordinary shareholders.

Cow Co's shareholders expect a return of 10% on their equity investment of $300 million (share capital 100 + retained earnings 200) ie 300 x 0.1 — $30 million.

Profits after tax are greater than $30 million so Cow Co is producing an adequate short-term return to its shareholders.