Introduction to Finance

Cost of Retained Earnings: Security Market Line (SML) Approach 
Chapter 12’s Learning Extension developed the security market line (SML), which can 
provide an estimate of shareholder required return based on a stock’s systematic risk. The 
security market line equation is, as follows: 
E
(
R
i
) = RFR + 
𝛽
i
(
R
MKT
– RFR)
It gives the required return as a combination of the risk-free return (RFR) and a risk premium 
that is the product of a stock’s systematic risk, measured by 
𝛽
i
, and the market risk premium 
(
R
MKT
– 
RFR
). The required shareholder return is the opportunity cost the fi rm must earn on 
its retained earnings. Thus, this is an estimate for the cost of retained earnings:
k
re
= 
E
(
R
i
) = RFR + 
𝛽
i
(
R
MKT
– RFR) 
(18-3)
5
Flotation costs were discussed in Chapter 11.

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18.3 Cost of Capital
573
For example, assume the current T-bill rate is 4.5 percent and analysts estimate the current 
market risk premium is above its historical average at 9.0 percent. Suppose also that analysts 
estimate Eastnorth Manufacturing’s 
𝛽
to be 1.30. What is Eastnorth Manufacturing’s cost of 
retained earnings, using the SML approach?
All the information we need in order to apply equation 18-3 was presented above:
k
re
= 
E
(
R
i
) = RFR + 
𝛽
i
(
R
MKT
– RFR) = 4.5% + [(1.3)(9%)] = 16.2 percent
Using the SML, Eastnorth Manufacturing’s cost of retained earnings is 16.2 percent.