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CS Executive · Corporate Accounting and Financial Management · Cost of Capital

In the context of cost of capital, why is a positive cost attributed to retained earnings even though the company pays no explicit dividend or interest on them?

Retained earnings have a cost because they represent an opportunity cost to equity shareholders. Had the profits been distributed, shareholders could have invested them elsewhere at a return for similar risk, so the firm must earn at least that return on retained funds.

  1. ABecause retained earnings carry a fixed contractual rate payable to lenders
  2. BBecause retained earnings are an opportunity cost: shareholders could have earned a return by investing the dividends elsewhereCorrect
  3. CBecause retained earnings are always cheaper than debt after tax
  4. DBecause retained earnings are legally required to bear interest under company law

Explanation

Retained earnings belong to equity shareholders. If profits were paid out, shareholders could reinvest them at a return of similar risk. This forgone return is the opportunity cost. Retained earnings carry no contractual interest, so the option on fixed rate is wrong.

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