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Meaning of Cost of Retained Earnings
The company is not to pay any dividends on retained earnings, it is therefore, observed that this source of finance is cost free.


Postini Alternative

This view seems to be based on the assumption that the company is a separate entity from its shareholders and it pays nothing to the shareholders to withhold these earnings. But this view is not correct. Retained earnings involve an opportunity cost. The opportunity cost of retained earnings is the dividend foregone by the shareholders by not putting funds elsewhere. Thus cost of Retained earnings is the return expected by the company.

From shareholders' point of view, the opportunity cost of Retained earnings is the rate of return that they can obtain by putting after tax dividend in some other securities of equal qualities, if earnings are paid to them as dividend in cash. And individual pays income tax on dividend hence he would only be able to invest the amount remained after paying individual income tax on such earnings. The value of his shares would also be increased in the market by an amount which after making provisions for any tax on capital gains, is equal to the net dividend he would have received after tax. It shows that necessary adjustments should be made for individual income tax and capital gain tax on such expected earnings to the shareholders in determining the opportunity cost to them. This can be expressed as follows-

                          (1 Ti) D
               Kr =   -------------
                         (1 To) P

Here :            Kr = Cost of retained earnings

                     Ti = Marginal income tax-rate applicable to an individual

                     To = Capital gain tax

                     D = Dividends per share

                     P = Price of share.

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