Question 2 (a)
Do retained earnings cost nothing?
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 2 (a) · 4 marksRetained earnings cost nothing. Do you agree?
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- Do you agree?A statement to judge: take a stand on it in your first line, give your reasons, and come back to it at the end.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Verdict and the "no cost" argument 1 mark 2 min
- 2 Opportunity cost of dividends foregone; implicit cost 2 marks 3 min
- 3 Measurement and conclusion 1 mark 2 min
Short on time? Step 2 carries 2 of the 4 marks: guard its minutes.
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
No, I do not agree. Retained earnings carry no explicit cost, but they do have a cost.
The argument that they are free. It is sometimes said that retained earnings involve no cost, because the firm is not required to pay any dividend on them.
- They belong to the shareholders. Retained earnings accrue to the firm only because the shareholders sacrifice the dividends they could have received from the available profits, and they expect a return on the profits retained.
- Opportunity cost. The cost of retained earnings is the return the shareholders could earn by investing the after-tax dividends in an alternative opportunity of equal quality: the opportunity cost of the dividends foregone. It is an implicit cost, the opportunity cost of funds to the firm.
- Measurement. It is measured like the cost of equity, Kr = D ÷ NP + g.
Conclusion. If retained earnings were treated as free, the firm would accept projects earning less than its shareholders could earn elsewhere, which would reduce their wealth. Retained earnings must therefore be charged at their opportunity cost in capital budgeting and in the weighted average cost of capital.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Verdict and the "no cost" argument | 1 |
| 2 | Opportunity cost of dividends foregone; implicit cost | 2 |
| 3 | Measurement and conclusion | 1 |
| Total | 4 |
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