What is cost of retained earnings?

Retained earnings are kept with the company for growth instead of distributing dividends to the shareholders. Therefore the cost of retained earnings refers to its opportunity cost which is the cost of foregoing dividends by the shareholders.

Therefore the cost of retained earnings is similar to the cost of equity without tax and flotation cost. Hence, it can be calculated as

Kr = Ke (1 – t) (1 – f),

Kr = Cost of retained earnings
Ke = Cost of equity
t = tax rate
f = flotation cost

Here, flotation cost means the cost of issuing shares.

EXAMPLE

If cost of equity of a company was 10%, tax rate was 30% and flotation cost was 5%, then
cost of retained earnings = 10% x (1 – 0.30)(1 – 0.05) = 6.65%.

From the above example and formula, it is clear that the cost of retained earnings would always be less than or equal to the cost of equity since retained earnings do not involve flotation costs or tax.

A company usually acquires funds from various sources of finance rather than a single source. Therefore the cost of capital of the company will be the weighted average cost of capital (WACC) of each individual source of finance. The cost of retained earnings is thus an important factor in calculating the overall cost of capital.

Another important factor of WACC is the cost of equity. The cost of equity is sometimes interchanged with the cost of retained earnings. However, they are not the same.