Suppose your firm is going to finance a new project 100% with retained earnings. Your boss claims that since the earnings are already being retained and that since no outside financing is required, the project should be evaluated at the risk-free rate of return. Is this appropriate? Are retained earnings risk-free? Why or why not?

Students should first recognize that retained earnings that appear on the right-hand-side of the statement of financial position have already been used to finance assets on the left-hand-side of the statement of financial position; they are no more "available" to finance new projects than existing debt is available for this purpose. Internally generated funds, on the other hand, (which is almost certainly what the boss is talking about) essentially belong to equity holders so the appropriate cost is the cost of equity. Moreover, the boss is basing the cost of capital on the source of funds, not the use.