Question

Do you know the answer? The most expensive source of capital is: 1. new common stock 2. debt 3. retained earnings 4. preferred stock

Answer 1

The answer is 1. new common stock.

The most expensive source of capital is new common stock because it has higher risk compared to other sources of financing and generally used for high risk projects. it also dilutes the earnings available to common stockholders and gets the least preference compared to debt and preferred stock. so after paying debt and preferred stockholders, if anything left will be given to common stock holders. due to high risk, dilutive nature and least preference common stockholders required higher return than other sources of financing which makes it most expensive source of capital.

debt is the less risky than common stock, gets first preference in payments with fixed payments and somewhat secured than common stock. so they required less return. it also generates tax shield which reduces after-tax cost of debt.

Preferred stock is also less risky than common stock, gets fixed dividends and preference than common stock. some firms issue preferred stock with cumulative dividend feature which means if firm is not able to pay dividend for any year than it gets accumulated and paid later. due to all these securities, return on preferred stock is lower than common stock.

retained earnings are earnings which a firm has already earned or have. it only has opportunity cost of capital which is lower than return on common stock.