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Cost of Retained Earnings and External Equity:
Equity finance may be calculated in two ways. Firstly by using Retained Earnings and then by issue of additional equity. The cost of equity or the return given by equity shareholders is the same in both cases. Irrespective of whether a firm raises equity finance either by retained additional equity or earnings, the cost of equity is the similar. The only dissimilarity is in floatation costs. There are no floatation costs for earnings whereas there is a floatation cost of 2 to 10% or sometimes even more for additional equity.
The companies do not usually distribute the entire profits earned by them by way of dividend among their shareholders. Some profits are retained by them for future expansion of the market. The cost of retained earnings is the earnings gain by the shareholders. In other words, the opportunity cost of retained earnings can be taken as the cost of retained earnings. It is same as the income that the shareholders would have otherwise earned by placing this money in alternative investments.