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The higher the firm's flotation cost for new common equity, the more likely the firm is to use...

Question:

The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.

True

False

Explain.

Flotation Costs:

Flotation costs is a term used in finance and accounting. It refers to the fees investment banks charge for underwriting a company for a debt or equity offering. Fees include underwriting fees, legal fees and registration fees. Flotation costs range from 2% to 10% depending on the nature of the transaction.

Answer and Explanation:

False. The higher the firm's flotation cost for new common equity, the more likely the firm is to use debt, not preferred stock. While preferred stock costs less than common stock, debt is less than both. Also, preferred stock does have flotation costs, they just aren't as high as they are for a new issue of common equity. Finally, the cost of retained earnings isn't the average return on assets, but the opportunity cost on alternative investments.


Learn more about this topic:

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Cost of Capital: Flotation Cost, NPV & Internal Equity

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18
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