The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

Question

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The cost of retained earnings is considered the opportunity cost of not distributing profits to shareholders, who could otherwise invest them elsewhere at a rate rs, which is the expected return on investments with similar risk.

The Reason Why Retained Earnings Have a Cost Equal to Rs