The cost of those retained earnings equals the return shareholders should expect on their investment. It is called an opportunity cost because the shareholders sacrifice an opportunity to invest that money for a return elsewhere and instead allow the firm to build capital.

How do you define retained earnings?

By definition, retained earnings are the cumulative net earnings or profits of a company after accounting for dividend payments. It is also called earnings surplus and represents the reserve money, which is available to the company management for reinvesting back into the business.

Is retaining earnings free of opportunity costs?

Retained earnings, in fact, are not without cost. Though it might seem that these funds are free, yet there is a very definite opportunity cost involved. The cost of reinvested profits to shareholders is the opportunity cost involved.

What is retained earnings and its advantages?

1. Increased stock value. Keeping your company earnings increases your balance sheet, which has a knock-on effect to stockholder equity and corresponding stock value. Retained profit makes your business look better on paper with more money in your accounts, in turn attracting further investment.

How is the cost of retained earnings computed?

6. ii) Cost of retained earnings when there is flotation cost and personal tax rate applicable for shareholders: Cost of retained earnings = Cost of equity x (1- fp) (1-tp) where, fp = flotation cost on re-investment by shareholders tp = Shareholders’ personal tax rate.

Why are retained earnings important?

Retained earnings are an important part of any business; providing you with the means to reinvest in or grow your business. Retained earnings can be used to pay additional dividends, finance business growth, invest in a new product line, or even pay back a loan.