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CA Intermediate · Financial Management and Strategic Management · Cost of Capital

Which of the following is the correct statement about the cost of retained earnings in the context of cost of capital?

The cost of retained earnings equals the opportunity cost of equity shareholders, meaning the return they could earn by investing the funds elsewhere at similar risk. It is not zero, because retained profits belong to shareholders who expect a return on them.

  1. AIt is zero because the company does not pay anything to outside investors
  2. BIt is equal to the opportunity cost of equity shareholders, i.e. the return they could earn by reinvesting the funds elsewhere at similar riskCorrect
  3. CIt is equal to the cost of debt because both are internal sources
  4. DIt is always lower than the cost of preference capital

Explanation

Retained earnings belong to equity shareholders, so retaining them has an opportunity cost equal to the return shareholders expect on similar-risk investments. Saying it is zero ignores this opportunity cost, which is why option A is wrong.

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