Question

Which of the following statements is NOT CORRECT?

a. When new stock is issued, the company pays an investment bank to handle the expenses and fees involved with selling the stock. These expenses are called flotation costs.

b. Flotation costs reduce the amount of capital the firm receives from a new stock issue. The company must make each dollar of the new issue work harder, so new investors earn their required rate of return. The new stock has a higher return (a higher cost), which is the stock's base "required rate of return" plus an adjustment for flotation costs.

c. There are two ways to raise common equity. One source is retained earnings, which means that the firm has set aside some of its annual profits to reinvest in the firm instead of paying a dividend to stockholders. The second source is the issue of new stock, which involves selling stock to the public.

d. The cost of retained earnings is less than the cost of new common stock due to flotation costs. While retained earnings may appear to be free money on the surface, there is an opportunity cost to them as these funds could be invested elsewhere and earning a return for shareholders. Due to the lower cost of retained earnings, companies generally prefer to use retained earnings to finance their projects, and only issue new common stock when they absolutely must.

e. There are two ways to raise common equity. One source is retained earnings that involves bringing in new funds from outside the company, which represents external equity. The second source is new stock issues that involves bringing in new funds from current stockholders of the company, which represents internal equity.

Answer 1

e. There are two ways to raise common equity. One source is retained earnings that involves bringing in new funds from outside the company, which represents external equity. The second source is new stock issues that involves bringing in new funds from current stockholders of the company, which represents internal equity.

Option E is the correct answer because retained earnings are funds kept aside the company from the annual profits, it is not something that could be brought into the company.

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