## Retained Earnings

### What is it?

Retained earnings represent the portion of profits not distributed as dividends but reinvested (ploughed back) into the business for future growth. It is an internal source of long-term finance.

### Key Characteristics

Characteristic	Detail
Belongs to Shareholders	Adds to net worth; increases shareholders' equity without issuing new shares
No Dilution of Control	No new shares issued → existing shareholders' control is unaffected
Cost-Effective	No flotation cost, no interest obligation, almost no risk
Used for Expansion	Funds capital expenditure, diversification, modernisation
Legally Required	Public companies must retain a reasonable portion of profits annually
Opportunity Cost	Decision to retain depends on whether return on reinvested earnings > cost of equity

### The Opportunity Cost Concept

Retained earnings are NOT free — they carry an opportunity cost
If shareholders could earn more by investing dividends elsewhere, retention destroys value
Retention is justified only when: Return on Reinvested Earnings > Cost of Equity Capital

Worked example

### Example 1

A company earns ₹5 lakh profit and retains ₹3 lakh instead of paying it as dividend. Shareholders' equity rises by ₹3 lakh without any new shares, dilution, or flotation costs.

### Example 2

If a firm's cost of equity is 12% but retained earnings can only be reinvested at 8% ROI, it is better to pay dividends — the opportunity cost of retention exceeds the return.

⚠️ Common exam mistakes

Treating retained earnings as 'free' — they have an opportunity cost equal to the return shareholders could earn elsewhere.
Confusing retained earnings with cash — a company may have high retained earnings but low cash if profits are tied up in receivables or inventory.
Assuming retained earnings require regulatory approval — while a reasonable retention is legally required, the amount retained beyond that is a management decision.

Reference:

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