Financial Management and Business Data Analytics · Cost of Capital

Cost of Retained Earnings: Formula and Problems

Updated 10 October 2026 · Fact-checked

Retained earnings are not free. Shareholders could have received the profit as dividend and invested it elsewhere, so they expect a return. The cost of retained earnings is the return they expect, usually taken as the cost of equity (Ke). Adjust it for personal tax and brokerage only when the question gives them.

Understand Cost of Retained Earnings

When a company earns profit, it can pay it out as dividend or keep it in the business. Money kept in the business is called retained earnings. It needs no issue process, no prospectus and no interest payment. This is why many students call it free money.

It is not free. The profit belongs to equity shareholders. If the company had paid it out, they could have invested it in other securities of similar risk and earned a return. By retaining it, the company takes away that chance. The return given up is the opportunity cost, and it is the cost of retained earnings.

Because retained earnings belong to the same equity shareholders, the risk is the same as for their existing shares. So the basic cost of retained earnings (Kr) equals the cost of equity (Ke). You can find Ke by the dividend growth model, the CAPM, or the earnings yield, whichever the question gives data for.

The difference from new equity shares lies in issue costs. New shares carry floatation costs, so their cost is higher than Ke. Retained earnings have no floatation cost, so Kr = Ke on the basic approach.

Some questions use the opportunity cost approach with tax and brokerage. If shareholders received the dividend, they would pay personal tax on it and pay brokerage to reinvest the balance. So the return they would have kept is lower. Kr is then Ke reduced by these two items. Use this version only when the question mentions tax rate on shareholders and brokerage or commission.

Key rules to remember

Basic cost of retained earnings: Kr = Ke; Used when no tax or brokerage is given. Ke is found by the dividend growth model, CAPM or earnings yield.
Cost of equity, dividend growth model: Ke = D1 ÷ P0 + g; D1 is the expected dividend at the end of year 1, P0 is the current market price, g is the constant growth rate. If D0 is given, D1 = D0 × (1 + g).
Cost of equity, CAPM: Ke = Rf + β × (Rm − Rf); Rf is the risk-free rate, Rm the market return, β the equity beta.
Cost of retained earnings with tax and brokerage: Kr = Ke × (1 − t) × (1 − b); t is the shareholders' personal tax rate and b is the brokerage or commission rate, both as decimals. Use only when the question gives them.

How to solve Cost of Retained Earnings questions

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

1Read the data and note whether the question asks for cost of retained earnings, new equity, or both.
2Find the cost of equity (Ke) using the method the data supports: dividend growth, CAPM or earnings yield.
3If D0 is given instead of D1, compute D1 = D0 × (1 + g) before using the formula.
4Check whether shareholders' tax rate and brokerage are given. If neither is given, Kr = Ke.
5If they are given, compute Kr = Ke × (1 − t) × (1 − b), converting percentages to decimals.
6Do not deduct any floatation cost from the price. That applies to new equity, not retained earnings.
7Write the final answer as a percentage and state a line on why the cost is not zero.

Quickest way: Ke first, adjust last

When to use it: Use in MCQs and in the first part of a longer WACC question where retained earnings are one source of funds.

Compute Ke in one line: D1 ÷ P0 + g or the CAPM.
Scan the question for the words tax on dividend, brokerage or commission.
If none, write Kr = Ke and move on.
If present, multiply Ke by (1 − t) and then by (1 − b).
Carry the result into the WACC table as the cost of the retained earnings line.

Common mistakes in Cost of Retained Earnings

Taking the cost of retained earnings as zero
No interest or dividend is paid out on it, so it looks free.
Fix: Remember the opportunity cost. Shareholders expect at least Ke on the funds retained.
Deducting floatation cost from the market price
Students copy the new equity share formula.
Fix: Use P0 as given. Floatation cost applies only to fresh issues.
Using D0 as D1 in the dividend growth model
The question gives the dividend just paid and students plug it in directly.
Fix: If the dividend was just paid, compute D1 = D0 × (1 + g) first.
Applying tax and brokerage when they are not given
Students memorise the adjusted formula and apply it every time.
Fix: Use the adjustment only when the question gives shareholders' tax rate or brokerage.
Using the company's tax rate for the adjustment
Tax shield on debt is fresh in mind from cost of debt.
Fix: The tax in this formula is the shareholders' personal tax rate on dividend. The company's tax rate is not used.
Entering the rate as a whole number in the formula
Mixing 20 with 0.20 in (1 − t).
Fix: Convert percentages to decimals before multiplying.

Worked examples

Example 1

A company's equity share has a market price of ₹200. It has just paid a dividend of ₹10 per share, which is expected to grow at 5% a year. Compute the cost of retained earnings.

Show the solution

Retained earnings belong to equity shareholders, so Kr = Ke.
D0 = ₹10 and g = 5%, so D1 = 10 × 1.05 = ₹10.50.
Ke = D1 ÷ P0 + g = 10.50 ÷ 200 + 0.05.
10.50 ÷ 200 = 0.0525.
Ke = 0.0525 + 0.05 = 0.1025, that is 10.25%.
No tax or brokerage is given, so Kr = Ke.

Answer: Cost of retained earnings = 10.25%

Example 2

The cost of equity of Shree Tools Ltd is 15%. Its shareholders are in the 20% personal tax bracket and pay brokerage of 2% when reinvesting dividends. Compute the cost of retained earnings.

Show the solution

Use Kr = Ke × (1 − t) × (1 − b).
1 − t = 1 − 0.20 = 0.80.
1 − b = 1 − 0.02 = 0.98.
Kr = 15% × 0.80 × 0.98.
15% × 0.80 = 12%.
12% × 0.98 = 11.76%.

Answer: Cost of retained earnings = 11.76%

Exam tips

In MCQs, the usual trap is the option 0% or nil. Reject it and choose the option equal to Ke.
Check for the words personal tax and brokerage before choosing between Kr = Ke and the adjusted formula.
In WACC problems, use book or market weights as asked, and keep the retained earnings line separate from new equity if their costs differ.
Write one sentence on opportunity cost in theory answers. It carries step marks.
Show D1 = D0 × (1 + g) as a separate line so you earn method marks even if the final figure slips.

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. It has no explicit payment, but it has an opportunity cost. Shareholders could have received the profit as dividend and earned a return elsewhere. That expected return is the cost.

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

On the basic approach they are equal, because both belong to the same shareholders and carry the same risk. The cost of new equity shares is higher because of floatation costs. With personal tax and brokerage given, cost of retained earnings is lower than Ke.

When do I adjust the cost of retained earnings for tax and brokerage?

Only when the question gives the shareholders' tax rate or brokerage. Then use Kr = Ke × (1 − t) × (1 − b). If they are not given, take Kr = Ke.

Which tax rate is used in the adjustment?

The personal tax rate of shareholders on dividend income. The company's tax rate is not used for retained earnings.