## Retained Earnings
Retained earnings are accumulated profits reinvested (ploughed back) into the business instead of being distributed as dividends. They are the principal internal long-term source of finance.
### Features
| Feature | Explanation |
|---|---|
| Source of long-term funds | Generated by ploughing back profits. |
| Belongs to shareholders | Increase the firm's net worth and belong to ordinary (equity) shareholders. |
| No additional risk | Create no debt obligation and entail minimal risk. |
| No ownership dilution | Unlike a fresh share issue, control stays with existing owners. |
| Legal & expansion needs | Public companies must retain a portion of profits to meet legal requirements and fund growth. |
| Dividend decision factor | Whether to retain depends on the company's return on investment vs. cost of equity. |
### The Retain-vs-Distribute Decision
The firm should retain earnings when the return it can earn on reinvestment exceeds the shareholders' cost of equity — i.e., reinvesting creates more value than shareholders could earn elsewhere. Otherwise, profits are better distributed as dividends.
### Key takeaway
Retained earnings are often seen as 'free', but they carry an opportunity cost equal to the cost of equity — shareholders forgo dividends, so the reinvestment must beat what they could earn on their own. They are attractive because they avoid issue costs, debt obligations, and ownership dilution.