Internal accruals Meaning
Internal accruals form part of the means of finance in respect of expansion projects. An existing company that goes for an expansion (or diversification or modernization) project may opt to finance a portion of the capital investment out of internal cash accruals. Depreciation which is not cash expenditure and profits retained after payment of dividends are the main sources of internally generated funds Apart from the internal funds that have already been generated, the likely internal generation during project implementation can also be used as a source for funding expansion projects.
Advantages of Internal Accruals
Internal accruals are viewed very favourably by most corporate managements for the following reasons:
1) Internal accruals are readily available Management does not have to talk to outsiders (shareholders or lenders)
2) Use of internal accruals, in contrast to external equity, eliminates issue costs and losses on account of under-pricing.
3) There is no dilution of control when a firm relies on internal accruals.
4) The stock market generally views an equity issue with scepticism. Internal accruals, however, do not carry any negative connotation.
Disadvantages of Internal Accruals
The disadvantages of internal accruals include the following:
1) The amount that may be available by way of internal accruals may be limited.
2) The opportunity cost of retained earnings is quite high as it is equal to the cost of equity- remember that retained earnings, in essence, represent dividends foregone by equity shareholders.
3) The opportunity cost of depreciation-generated funds is equal to the weighted average cost of capital of the firm.
4) Many firms do not fully appreciate the opportunity costs of retained earnings and depreciation-generated funds. They tend to impute a low cost to internal accruals.
Comforted by the easy availability of internal accruals and the notion that they have a low cost, managements may invest in sub-marginal projects that have a negative impact.