Question

is the cost of capital irrelevant if the company uses retained earnings to fund capital equipment? please explain

Answer 1

The cost of capital means the expense for using the capital or the reward which is paid to the providers of cash for using the fund as capital. There are various components in the capital structure of a company. It includes, Equity share, preference share, debentures, and borrowings. Each of such source of fund is having a cost, the cost for equity share capital is the dividend paid to the equity shareholders, in the same way the preference dividend is the cost of preference share capital and the interest on debenture and the loan is the cost of borrowed capital. The overall cost of capital includes the weighted average of such individual sources of capital. Retained earnings is the retained profit which is attributable to the equity shareholders, hence it is a part of the equity capital. Therefore when calculating the weighted average cost of capital the cost of retained earnings also needs to be considered and as it is a part of the owners' equity the cost of equity share capital is generally assigned to the retained earnings also. Therefore, if the company is using the retained earnings for financing the short term and long term needs of the business, then also it has a cost and is relevant and well justified. For analyzing the capital structure of the company the cost of retained earnings also must be considered.

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