Question

Retained Earnings. Why is there a cost to the firm for retaining earnings to fund investments?

Answer 1

A company pays dividends out of its earnings. This payment reduces the retained earnings of the company. Suppose a company needs common stock financing. It has two choices - one, it can issue additional stock so that its retained earnings is not touched and shareholders still get their dividend; two, the company does not pay out dividends and increases its common equity by way of retained earnings. Thus, the cost of retained earnings is equivalent to the cost of issuing a fully subscribed additional common stock. This is why, using retained earnings has a cost associated with it, the opportunity cost which the shareholders forego to get dividends and invest elsewhere for a return and instead, put that money back into the company for its growth.