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

Which one of the following is generally treated as the cost of retained earnings under the dividend growth approach, assuming no personal tax or brokerage adjustment?

The cost of retained earnings is taken as the cost of equity without flotation costs. Retained profits belong to equity shareholders, who could have received them as dividends and reinvested them elsewhere, so the opportunity cost equals their required return, not zero.

  1. AThe same as the cost of external equity ignoring floatation costsCorrect
  2. BThe cost of debt before tax
  3. CThe preference dividend rate
  4. DZero, since no cash is raised from outside

Explanation

Retained earnings belong to equity shareholders, who expect a return on them equal to their required return. So the cost equals the cost of equity without flotation costs. Treating it as zero ignores the opportunity cost of shareholders' funds.

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