Cost of Retained Earnings
Retained earnings, as a source of finance for investment proposals, differ from other sources debt preference shares and equities. The use of debt is associated with a contractual obligate a fixed state of interest to the suppliers of funds and, often, repayment of principal at predetermined due. An almost similar kind of stipulation applies to the use of preference also. In the case of ordinary shares, although there is no provision for any predetermined to the shareholders, yet a certain expected rate of dividend provides a starting point computation of cost of equity capital. That retained earnings do not involve any formal rent to become a source of funds is obvious. In other words, then is no obligation is implied on a firm to pay a return on retained earnings. Apparently, retained earnings no cost since they represent funds which have not been raised from cost contention that retained earnings. Are free of cost, however, is not correct. On the contrary involve cost like any other source.
It is true that a firm is not obligate to pay a return (dividend or interest) on retained. But retention of earnings does have implications for the shareholders of the firm. If earn firm obtained, they would have paid out to the ordinary shareholders as dividends words, retention of earning implied. Thus, using of dividends from holders of ordinary when earnings are, thus, retained. shareholders are forced to forego the equity-holders are, an opportunity cost. Thus, retained earnings opportunity cost. In other of, the firm required to earn on the retained least equal to the rate that would haw been earned by the shareholders if there were, this is the cost of retained earnings. Therefore, the cost of retained earnings may be defined as opposite cost in terms from the equity shareholders.
The alternative use of retained earnings is based on external. According to this approach the alternative to retained earnings is external investment of funds by the firm. In other word, the opportunity cost of retention of earning is the return that could not earned by investing of the funds in another by the firm in, would be obtained by the shareholders on other investment. The firm should can earn from external investment opportunistic, by retained then doing the firm should here. In mind that it such investment opportunist. Is the degree of risk as that of the firm itself. The rate of return that could be earning, thus earned the opportunist cost of retained a return would given the cost of return earning. The under the assumption of external shield mention would be investment. Approximately merits of this approach art obvious, here is simply the return on direct inconstant by the firm itself. Since the investments of funds are assumed to be made by the firm itself, this return would not be all by the tax brackets in which the various share-holders of the firm. The approach in other words, can be consistently applied. The external-yield criterion, therefore, represents an economic: By justifiably opportunity cost.
In brief, the cost of retained earnings represents: The opportunity cost in terms of the return on their investment in another enterprise by the firm whose, cost of retained earnings is considered. The opportunity cost given by the external yield criterion which can be consistently applied can be said to measure the likely to be equal. Therefore, k, should be used as k, but the merit would be lower than the former due to differences in notation cost and due to dividend payment tax.