Earning generated by a firm should be distributed ultimately among the equity shareholders. However, if the entire earnings are not distributed and a part is retained by the firm, then these retained earning are available for reinvestment of the firm. As the retained earning increases the shareholders equity in the same way as the new issue of equity share capital would do, the retained earnings are often considered as subscription to additional share capital by existing equity shareholders. However, the firm is not required to pay dividend on this part of shareholders funds ( i.e., the retained earnings portion ), so it may be argued that the retained earning have no cost as such. But this is not true. The cost of retained earning must be considered as the opportunity cost of the foregone dividends. From the point of view of equity shareholders, any earning retained by the firm could have been profitably invested by the equity shareholders themselves, had these been distributed to them. Thus, there is an opportunity cost involved in the firm retaining the earnings and an estimation of this cost can be taken up as a measure of cost of capital of retained earnings, k_r ,.


The cost of retained earnings, k_r, is often taken as equal to the cost of equity share capital, k_e , since the retained earnings are viewed as the fresh subscription to the equity share capital. If a firm has to decide whether to raise funds by issuing new equity shares or by retaining earnings, it will have to find out the rate of return at which the investors will be indifferent between whether the firm distributes the earnings or reinvests these earnings for future growth. This is reflected in market price of the share which is used to determine the cost of equity. If the investors are not getting the expected returns from the firm’s reinvestment , they will tend to sell their holding, forcing down the price until they get the expected returns. By lowering the share price, the investor maintain the required rate of return. Therefore, the share price fully reflect the cost of capital of the retained earning. So, k_r  =  k_e. It may be noted that the cost of retained earning is not to be adjusted for tax, for flotation cost and for the under pricing. While retaining the earning, the firm does not in any way incur any such cost and the earning to be retained are already after tax.
 
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