Is retained earnings cost free? Is debt the cheapest source?

(i) "Retained earnings is cost free." The statement is not correct.

• It is argued that retained earnings cost nothing because the firm pays no dividend or interest on them and incurs no issue costs. That is true of their explicit cost only.
• Retained earnings belong to the equity shareholders. They are retained only because the shareholders give up dividends they could have received and invested elsewhere, and they expect a return on the profits ploughed back.
• Their cost is therefore an opportunity cost: the return the shareholders could earn by investing the dividends forgone in an alternative of equal risk. It can be measured as kr = D ÷ NP + g.

So retained earnings have no explicit cost but do have an implicit cost, and using them in a project that earns less than that cost lowers shareholders' wealth.

(ii) "Debt is the cheapest source of finance." The statement is true only up to a point.

• Why debt is cheap. Lenders bear less risk than shareholders (interest is a fixed, prior claim), so the rate of interest is lower than the return equity holders require. Interest is also allowed as an expense for tax, so it saves tax (a tax shield) and lowers the effective cost of debt.
• The hidden cost. Using more debt raises the financial risk borne by the equity shareholders, so the cost of equity rises. Under the net operating income view, the advantage of the cheaper debt is exactly offset by the higher cost of equity. Beyond a prudent level, lenders also demand higher interest, and the risk of insolvency rises.

So debt is the cheapest source in its explicit cost, but it is not cheap without limit: the rise in the cost of equity and in financial risk must be weighed against it.