Equity finance may be obtained in two ways. Firstly by utilizing Retained Earnings and secondly by issue of additional equity. The cost of equity or the return required by equity shareholders is the same in both cases. Irrespective of whether a firm raises equity finance either by retained earnings or additional equity, the cost of equity is the same. The only difference is in floatation costs. There are no floatation costs for retained earnings whereas there is a floatation cost of 2 to 10% or sometimes even more for additional external equity.

The companies do not generally 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 business. The cost of retained earnings is the earnings foregone by the shareholders. In other words, the opportunity cost of retained earnings may be taken as the cost of retained earnings. It is equal to the income that the shareholders could have otherwise earned by placing these funds in alternative investments.

Retained earnings, as a source of finance for investment proposals differ from other sources like debt, preference shares and equities. There are two alternatives or opportunities to the retention of earnings – First, the amount retained would have been distributed to the shareholders who in turn, would invest it and earn a return on it and second, the firm itself could utilize them in external investment opportunities.

Accordingly, there could be two possible approaches to evaluate the cost of retained earnings. The first of these criteria is based on what shareholders are able to obtain on other investments, while second approach is expressed as "external yield criterion".

The cost of equity capital for Company X is 8.67%. The average tax rate of the shareholders is 25% and the brokerage costs amounts to 3%. Calculate the cost of retained earnings.

Kr = 0.0867 (1 - 0.25) (1 - 0.03) -> 0.0631 or 6.31%

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