As you know, dividends are paid out of a firm's earnings. Their payment, made in cash to common stockholders, reduces the firm's retained earnings. Suppose a firm needs common stock equity financing of a certain amount. It has two choices relative to retained earnings: It can issue additional common stock in that amount and still pay dividends to stockholders out of retained earnings, or it can increase common stock equity by retaining the earnings (not paying the cash dividends) in the needed amount. In a strict accounting sense, the retention of earnings increases common stock equity in the same way that the sale of additional shares of common stock does. Thus the cost of retained earnings, rr, to the firm is the same as the cost of an equivalent fully subscribed issue of additional common stock. Stockholders find the firm's retention of earnings acceptable only if they expect that it will earn at least their required return on the reinvested funds.
Viewing retained earnings as a fully subscribed issue of additional common stock, we can set the firm's cost of retained earnings, rf, equal to the cost of common stock equity as given by Equations 11.5 and 11.6.fi rf = rs (n.7)
It is not necessary to adjust the cost of retained earnings for flotation costs, because by retaining earnings, the firm "raises" equity capital without incurring these costs.
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