Corporate Accounting and Financial Management · Cost of Capital

Cost of Retained Earnings: Formula and Problems

Updated 11 October 2026 · Fact-checked

Retained earnings are not free. Shareholders could have received that money as dividends and invested it elsewhere, so the cost is their opportunity cost. Compute it like the cost of equity, Ke = D1 ÷ P0 + g, then multiply by (1 − personal tax rate) and (1 − brokerage rate) if 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. Many students think kept profit costs nothing because no one is paid interest on it. This is wrong.

Retained earnings belong to equity shareholders. If the company had paid them out, shareholders could have invested the money elsewhere and earned a return. By keeping the money, the company gives up that return for them. This forgone return is the opportunity cost, and it is the cost of retained earnings.

The company must therefore earn at least this return on the reinvested funds. If it earns less, shareholders would have been better off receiving the dividend. So the cost of retained earnings acts as the minimum acceptable return for projects financed from internal funds.

In theory, the cost of retained earnings equals the cost of existing equity (Ke), because the shareholders' expected return is the same. The difference appears in practice. A shareholder who receives a dividend pays personal income tax on it, and then pays brokerage to reinvest what is left. So the forgone return is lower by those amounts. This is why exam questions adjust Ke for tax and brokerage.

The key contrast: new equity shares involve flotation costs paid by the company, so the cost of new equity is higher. Retained earnings have no flotation cost. That is why Kr is usually equal to or slightly lower than the cost of new equity.

Key rules to remember

Cost of retained earnings (basic): Kr = Ke = D1 ÷ P0 + g; D1 is the expected dividend next year, P0 is the current market price, g is the constant growth rate. Use when no tax or brokerage is given.
Adjusted for personal tax and brokerage: Kr = Ke × (1 − t) × (1 − b); t is the shareholder's personal tax rate and b is the brokerage rate on reinvestment. Apply only the adjustments the question gives.
Cost of equity by dividend growth: Ke = (D0 × (1 + g)) ÷ P0 + g; Use when the last dividend D0 is given, not D1. Find D1 first.
Cost of equity by CAPM: Ke = Rf + β × (Rm − Rf); Use when the question gives risk-free rate, beta and market return.
Earnings approach: Ke = E1 ÷ P0; Used when growth is nil and all earnings are assumed distributed.

How to solve Cost of Retained Earnings questions

Follow this order for any question on cost of retained earnings. The main skill is first finding Ke correctly, then applying only the adjustments the question mentions.

1Read the question and note what is given: D0 or D1, P0, g, tax rate, brokerage rate, beta and market data.
2Check whether the dividend is D0 (last paid) or D1 (expected). If it is D0, compute D1 = D0 × (1 + g).
3Choose the method for Ke: dividend growth model, earnings approach, or CAPM, based on the data given.
4Calculate Ke as a percentage.
5Check for personal tax on dividend and brokerage on reinvestment. If given, multiply Ke by (1 − t) and then by (1 − b).
6Ignore company flotation costs for retained earnings. They apply only to new issues.
7State the answer clearly: Kr = ___ %, and add one line that retained earnings carry an opportunity cost.

Quickest way: Three-line shortcut

When to use it: Use when the question gives D0 or D1, price and growth, with optional tax and brokerage rates.

Write D1 (convert from D0 if needed), then Ke = D1 ÷ P0 + g.
Write the adjustment factor: (1 − t) × (1 − b) using decimals.
Multiply: Kr = Ke × factor. Round only at the end.

Common mistakes in Cost of Retained Earnings

Writing the cost of retained earnings as zero.
Because there is no interest or dividend promised on retained profit, it looks free.
Fix: Always explain the opportunity cost. Kr is at least the return shareholders expect on equity.
Using D0 in place of D1 in D1 ÷ P0 + g.
The question gives the dividend just paid and students plug it in directly.
Fix: Check the wording. If the dividend is already paid, multiply by (1 + g) first.
Deducting flotation cost from the price for retained earnings.
Students copy the new equity method and reduce P0 for issue cost.
Fix: Retained earnings have no issue cost. Use the market price P0 as it is.
Applying the corporate tax rate to Kr.
Students remember that debt cost is adjusted for tax and apply the same idea here.
Fix: Dividends are not tax-deductible for the company. Only the shareholder's personal tax rate applies, and only if given.
Adding tax and brokerage instead of multiplying the factors.
The two adjustments are treated as one combined rate, such as 20% + 2%.
Fix: Use Ke × (1 − t) × (1 − b). Each reduces the amount that remains.
Confusing Kr with the cost of new equity.
Both use the same base formula, so the difference is forgotten.
Fix: Remember: new equity has flotation cost and is usually higher; retained earnings have none.

Worked examples

Example 1

The equity shares of Bharat Textiles Ltd are quoted at ₹200. The company paid a dividend of ₹10 per share last year and dividends are expected to grow at 5% every year. Compute the cost of retained earnings. Ignore tax and brokerage.

Show the solution

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, which is 5.25%.
Ke = 5.25% + 5% = 10.25%.
No tax or brokerage is given, so Kr = Ke.

Answer: Cost of retained earnings = 10.25%.

Example 2

Sundaram Foods Ltd has a cost of equity of 15%. Its shareholders are in the 20% tax bracket on dividend income, and they pay 2% brokerage when they reinvest the dividends. Compute the cost of retained earnings.

Show the solution

Ke = 15%, t = 20% = 0.20, b = 2% = 0.02.
Kr = Ke × (1 − t) × (1 − b).
(1 − 0.20) = 0.80 and (1 − 0.02) = 0.98.
Combined factor = 0.80 × 0.98 = 0.784.
Kr = 15% × 0.784 = 11.76%.

Answer: Cost of retained earnings = 11.76%.

Exam tips

Write one line on opportunity cost in every theory-linked answer. It earns marks even if the arithmetic slips.
Underline whether the question gives D0 or D1 before you start. This is the most common trap.
Show the adjustment factor separately, such as 0.80 × 0.98 = 0.784, so marks are awarded for method.
Do not apply flotation cost or corporate tax. If a question gives them, they belong to other sources of capital in the same problem.
In WACC questions, use Kr as the cost of the retained earnings line and weigh it by its book or market value as directed.

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 have an opportunity cost. Shareholders could have received the profit as dividend and invested it elsewhere. The company must earn at least that expected return on the retained funds.

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

Without tax and brokerage, they are equal, because both reflect the return shareholders expect. With personal tax and brokerage, Kr is lower than Ke. It is also lower than the cost of new equity, which includes flotation cost.

Why is brokerage deducted in the cost of retained earnings?

If shareholders received the dividend, they would pay brokerage to reinvest it. The return they actually forgo is therefore smaller. Multiplying by (1 − b) reflects this.

Do I use the corporate tax rate for the cost of retained earnings?

No. Dividends are paid from after-tax profit and are not deductible for the company. Use only the shareholder's personal tax rate, and only when the question gives it.