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

Which statement about the cost of retained earnings is correct as per the traditional approach taught at Foundation/Intermediate level?

Cost of retained earnings is taken as equal to the cost of equity, ignoring shareholders' personal tax and brokerage. Retained profits belong to shareholders, who could have earned a return elsewhere, so there is an opportunity cost. It is therefore not zero.

  1. AIt is zero because no payment is made to shareholders
  2. BIt equals the cost of equity, ignoring personal tax and brokerageCorrect
  3. CIt equals the post-tax cost of debt
  4. DIt is always lower than the cost of preference capital

Explanation

Retained earnings are shareholders' funds with an opportunity cost, so the cost equals the cost of equity when personal taxes and brokerage are ignored. It is not zero, and it is unrelated to the debt cost.

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