Consider the discussions concerning the cost of common equity.What is the relationship between the cost of retained earnings (internal equity), rs, and the cost of new common equity (external equity), re? A)rs re, because new stockholders are willing to accept a lower return and "pay their dues" before they start receiving the higher returns that existing, loyal stockholders receive. B)0 = rs

Question

Consider the discussions concerning the cost of common equity.What is the relationship between the cost of retained earnings (internal equity), rs, and the cost of new common equity (external equity), re?
A)rs > re, because new stockholders are willing to accept a lower return and "pay their dues" before they start receiving the higher returns that existing, loyal stockholders receive.
B)0 = rs < re, because there is no "real" cost to the income that the firm decides to retain to reinvest in assets rather than payout to common stockholders as dividends.
C)0 < rs < re, because there is a real cost to retaining income (earnings) for reinvestment, but the firm has to pay flotation costs when issuing new common stock.
D)rs = re, because they both represent essentially the same source of funds, so they must have the same cost.
E)None of the above is a correct answer.

Quizplus · Accepted Answer

Retained earnings (rs) have a lower cost than new common equity (re) because no flotation costs are associated with them. However, there is still a cost to retaining earnings because it represents a sacrifice of the firm's ability to pay dividends to shareholders. On the other hand, new common equity generally requires payment of underwriting and other flotation costs. Therefore, the cost of retained earnings is less than the cost of new common equity, but both have a real cost.

Consider the Discussions Concerning the Cost of Common Equity