Question

What are the two primary sources of equity capital? Explain why there is a cost to using reinvested (retained) earnings; that is, why aren’t reinvested earnings a free source of capital?

Answer 1

The two primary sources of equity capital are PAID-IN CAPITAL AND RETAINED EARNINGS

1.PAID UP CAPITAL

One of the two main sources of stockholders equity is paid-in capital. Paid in capital is the money brought into the business by selling stock in the company. These funds are often the initial source of stockholders' equity. Over time, firms might sell additional stock to raise money for various reasons. For example , a company might need funds to expand into new market. When more stock is sold, the firm's stockholders' equity increases.

2.RETAINED EARNINGS

Retained earnings are the other main source of stockholders equity. These are made up of the accumulated yearly profits earned by the firm,minus any dividend payments. For example if a firm records a net profit of $100 million at the end of 2018, then the stockholders' equity on the balance sheet increases by the same amount. These profits are a reflection of how successful a company has operated over time.

REASON FOR COST ASSOCIATION WITH FIRM'S RETAINED EARNINGS

Net income can either be retained earnings or dividends. The reason why retained earnings are retained is that this amount of money can gain a better return than that it is divided and invested by the shareholders. The investors of the company request a rate of return on the investments. That is the cost associated with the firm's retained earnings.