Final answer:
The cost of raising funds from retained earnings is indeed typically cheaper than debt financing, as using retained earnings avoids interest payments and doesn't involve outside investors or lenders. However, this method does carry an opportunity cost, which represents the foregone benefits shareholders would have received if profits were distributed as dividends.
Step-by-step explanation:
The statement that the cost of raising funds from retained earnings is usually a lot cheaper than the cost of debt financing is true. Retained earnings are the portion of a company's profits that is kept within the company instead of being distributed to shareholders or used to pay off debt. Using these funds removes the need for external financing, which can come with additional costs such as interest payments. When a company uses retained earnings, it does not have to engage with external lenders or investors, keeping the decision-making process internal and avoiding control dilution which can happen with equity financing.
However, the notion that retained earnings are cost-free is a misconception. While there are no direct interest costs, there is an opportunity cost in the form of foregone dividends to shareholders. Opportunity cost reflects the benefits the shareholders would have received if the profits were distributed instead of being reinvested. Still, compared to debt financing, which involves mandatory interest payments and could potentially pose financial risk if the firm's income decreases, retained earnings provide a cheaper and less risky source of financing.