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IAI Actuarial Core Principles · Business Finance · Structure and methods of financing a company

Which statement about retained earnings as a source of finance is correct?

Retained earnings carry an opportunity cost equal to the return shareholders require on equity of similar risk, since they could have received the money as dividends and invested it elsewhere. It is therefore not free, and it is not equal to the cost of debt.

  1. AIt has no cost because no dividend or interest is paid on it
  2. BIt carries an opportunity cost, being at least the return shareholders could earn elsewhere at similar riskCorrect
  3. CIt has the same cost as the interest rate on debentures
  4. DIt is cheaper than debt because it is not taxed
  5. It must always be raised through a public issue

Explanation

Retained profits belong to shareholders, who could have received them as dividends and reinvested elsewhere. So the cost is the shareholders' required return, an opportunity cost. Treating it as free is a common error. It is not linked to debenture interest or tax shields.

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