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

Which of the following is the correct treatment of the cost of retained earnings in the weighted average cost of capital (WACC) computation?

Retained earnings are costed at the cost of equity because they are shareholders' funds kept in the business. Shareholders expect the same return they would demand on fresh equity, so the opportunity cost applies. Treating retained earnings as free would understate the weighted average cost of capital.

  1. AIt is treated as zero because no payment is made to outsiders
  2. BIt is treated as the opportunity cost of equity shareholders' funds, equal to the cost of equityCorrect
  3. CIt equals the dividend rate on preference shares
  4. DIt equals the post-tax cost of debt

Explanation

Retained earnings belong to equity shareholders, who could have earned a return by receiving them as dividends and reinvesting. Hence the cost of retained earnings is the opportunity cost, taken equal to the cost of equity. Treating it as zero ignores this opportunity cost and understates WACC.

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