Consider the Discussions Concerning the Cost of Ordinary Equity

question 75

Multiple Choice

Consider the discussions concerning the cost of ordinary equity.What is the relationship between the cost of retained earnings (internal equity) , rs, and the cost of new ordinary equity (external equity) , re?

• A) rs > re, because new shareholders are willing to accept a lower return and "pay their dues" before they start receiving the higher returns that existing, loyal shareholders 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 ordinary shareholders 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 ordinary shares.
• 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.

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