Comment on the following: The firm is not required to pay dividends on retained earnings, so it may be argued that the retained earnings have no cost as such.

Earnings generated by a firm are distributed among the equity shareholders. However, if the entire earnings are not distributed and a part of it is retained by the firm, then these retained earnings are available for reinvestment within the firm. The firm is not required to pay dividends on retained earnings, so it may be argued that the retained earnings have no cost as such. But this is not true. The cost of retained earnings must be considered as the opportunity cost of the dividends foregone. From the point of view of equity shareholder, the earnings could have been profitably invested by them, had these been distributed to them. Thus, there is an opportunity cost involved in the firms retaining the earnings and an estimation of this cost may be considered as a measure of cost of capital of retained earnings. The cost of retained earnings are often taken as equal to the cost of equity. However, it is to be noted that retained earnings are not adjusted for tax, floatation cost and underpricing. While retaining the earnings, the firm does not in any way incur any such cost and the earnings retained are already after tax.