Financial Management and Strategic Management · Cost of Capital

Cost of Retained Earnings: Formula, Tax and Brokerage Adjustments

Updated 4 October 2026 · Fact-checked

Cost of retained earnings is the return shareholders expect on profits the company keeps instead of paying out. It is an opportunity cost. Compute it like the cost of equity, then adjust for shareholders' personal tax and brokerage: Kr = Ke × (1 − tax rate) × (1 − brokerage rate).

Understand Cost of Retained Earnings

When a company earns profit, it can pay it out as dividend or keep it in the business. Many students think kept profit is free because the company pays no interest or dividend on it. This is wrong.

The profit belongs to equity shareholders. If the company had paid it out, they could have invested it elsewhere and earned a return. By retaining it, the company takes away that chance. The return they give up is the opportunity cost of retained earnings.

So the company must earn at least what shareholders could have earned on similar-risk investments. If it cannot, it should pay the money out. This is why the basic cost of retained earnings equals the cost of equity (Ke). Both are found with the same models: dividend growth model, CAPM or earnings model.

There is one difference in exam questions. A new equity issue has floatation costs. Retained earnings have none, so no floatation cost is deducted. Instead, the textbook approach adjusts for what the shareholder would have lost if the dividend had been paid and reinvested: personal income tax on the dividend and brokerage on buying new shares. Both reduce the amount actually reinvested, so the effective cost is lower than Ke.

Remember: retained earnings are not free. They cost slightly less than new equity, because there is no floatation cost, and, when the question gives them, the tax and brokerage adjustments reduce the cost further.

Key rules to remember

Basic cost of retained earnings: Kr = Ke; Use when the question gives no personal tax or brokerage. Find Ke by the dividend growth model, CAPM or earnings model.
Dividend growth model for Ke: Ke = (D1 ÷ P0) + g; D1 = expected dividend next year = D0 × (1 + g). P0 is the current market price. No floatation cost is deducted for retained earnings.
CAPM for Ke: Ke = Rf + β × (Rm − Rf); Use when risk-free rate, beta and market return or premium are given.
Cost of retained earnings after personal tax and brokerage: Kr = Ke × (1 − Tp) × (1 − B); Tp = shareholders' personal tax rate; B = brokerage rate, both as decimals. Apply only the adjustments the question mentions.
Adjustment for tax only or brokerage only: Kr = Ke × (1 − Tp) or Kr = Ke × (1 − B); If only one item is given, apply only that factor.

How to solve Cost of Retained Earnings questions

Use this order for any question on the cost of retained earnings.

1Read the question and note what is given: dividend, growth, price, beta, market return, personal tax rate, brokerage rate.
2Decide the model for Ke. Use the dividend growth model if dividend and growth are given; CAPM if beta and market data are given.
3Compute D1 first if D0 and g are given: D1 = D0 × (1 + g). Do not use D0 directly.
4Calculate Ke as a percentage. Do not deduct any floatation cost, because retained earnings have none.
5Check for personal tax and brokerage. If neither is given, Kr = Ke.
6If given, convert rates to decimals and apply Kr = Ke × (1 − Tp) × (1 − B).
7State the final Kr clearly, rounded as the question asks, and add one line that retained earnings carry an opportunity cost.

Quickest way: Three-check shortcut

When to use it: Use for MCQs and for the first lines of a written answer when time is short.

Check 1: Is there a personal tax or brokerage figure? If not, the answer is simply Ke.
Check 2: Is D0 given instead of D1? Multiply by (1 + g) before dividing by price.
Check 3: Multiply Ke by (1 − Tp) and (1 − B) only for the items given.
In MCQs, eliminate options that equal Ke when tax or brokerage is given, and options larger than Ke, since the adjustments only reduce it.
In written answers, write the formula, the substitution and the final percentage on separate lines to earn step marks.

Common mistakes in Cost of Retained Earnings

Treating retained earnings as free capital with zero cost.
No interest or dividend is visibly paid on them.
Fix: Remember the opportunity cost: shareholders could have reinvested the money. Cost is at least the adjusted Ke.
Deducting floatation cost from the price while computing Kr.
Students copy the new equity formula, Ke = D1 ÷ (P0 − F) + g.
Fix: Retained earnings involve no issue, so no floatation cost. Use P0 as it is.
Using D0 instead of D1 in the dividend growth model.
The question states the dividend just paid and students plug it in directly.
Fix: Always check the wording. If it is the dividend already paid, compute D1 = D0 × (1 + g).
Adding tax and brokerage to Ke instead of reducing it.
Students think tax and brokerage are costs that raise the cost.
Fix: They reduce the amount the shareholder could have reinvested, so use the (1 − Tp) and (1 − B) factors, which lower Kr.
Using percentages directly in the formula, such as Ke × (1 − 30).
Rates are not converted to decimals.
Fix: Write 30% as 0.30 and 2% as 0.02 before substituting.
Applying the company's corporate tax rate instead of the shareholders' personal tax rate.
Tax is associated with cost of debt, where the corporate rate is used.
Fix: Use only the personal tax rate given for shareholders. Corporate tax plays no role here.

Worked examples

Example 1

A company's equity shares are quoted at ₹200. It paid a dividend of ₹10 per share last year, and dividends are expected to grow at 5% per year. Compute the cost of retained earnings. Shareholders' personal tax rate is 20% and brokerage on reinvestment is 2%.

Show the solution

D0 = ₹10, g = 5%, so D1 = 10 × 1.05 = ₹10.50.
Ke = D1 ÷ P0 + g = 10.50 ÷ 200 + 0.05 = 0.0525 + 0.05 = 0.1025, or 10.25%.
Apply personal tax: 1 − 0.20 = 0.80.
Apply brokerage: 1 − 0.02 = 0.98.
Kr = 10.25% × 0.80 × 0.98 = 10.25% × 0.784 = 8.036%.

Answer: Cost of retained earnings is about 8.04%.

Example 2

The risk-free rate is 7%, the expected market return is 13% and a company's equity beta is 1.2. Shareholders pay 10% personal tax on dividends; ignore brokerage. Find the cost of retained earnings.

Show the solution

Market premium = 13% − 7% = 6%.
Ke = Rf + β × (Rm − Rf) = 7% + 1.2 × 6% = 7% + 7.2% = 14.2%.
No brokerage is given, so only the tax factor applies: 1 − 0.10 = 0.90.
Kr = 14.2% × 0.90 = 12.78%.

Answer: Cost of retained earnings is 12.78%.

Exam tips

Read for words like 'personal tax' and 'brokerage'. They signal that Kr differs from Ke; their absence means Kr = Ke.
In WACC problems, retained earnings usually appear as a separate component with its own weight. Use book value or market value weights as the question directs.
Always show D1 working. Step marks are often given for D1 and Ke even if the final figure goes wrong.
Write a one-line note that retained earnings are not free. Theory-based short questions on this are common.
For theory questions, contrast retained earnings with new equity: same base cost, but no floatation cost for retained earnings.

Practice questions from Cost of Capital

Cost of Retained Earnings in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Retained Earnings: frequently asked questions

Is retained earnings free of cost?

No. Retained earnings belong to equity shareholders, who give up the chance to invest the money elsewhere. That lost return is the opportunity cost, so the company must earn at least that return.

What is the difference between cost of retained earnings and cost of equity?

The base figure is the same, since shareholders expect the same return. Retained earnings have no floatation cost, and when personal tax and brokerage are given, the cost of retained earnings is Ke adjusted downward for them. New equity carries floatation cost and has a higher cost.

How do I calculate cost of retained earnings with tax and brokerage?

First compute Ke using the dividend growth model or CAPM. Then multiply by (1 − personal tax rate) and by (1 − brokerage rate). Use decimals and apply only the items the question gives.

Should I use the company's tax rate for retained earnings?

No. Only shareholders' personal tax is relevant here. The corporate tax rate is used for the after-tax cost of debt, not for retained earnings.