Question

The cost of retained earnings is less than the cost of new outside equity capital. Consequently, it is totally irrational for a firm to sell a new issue of stock and to pay cash dividends during the same year. Discuss the meaning of those statements.

Answer 1

Answer:

Explanation: It implies that no cost of floatation is associated with he issuance of common stock and the cost of retained earnings is less than the cost of new outside equity capital. By this, a firm shouldn't be advised to pay dividends as it needs to exhaust all of her retained earnings before raising capital since the cost of retained earnings is lower than the cost of issuing new shares. The firm should opt to raise more capital by issuing new stocks only after it has exhausted all its retained earnings. Thus, issuing new stocks and paying dividends during the same year results in unnecessary incurrence of costs of capital and is considered to be irrational.

Answer 2

Answer:

Explanation:

Since the retained earning of the firm is lower than the stock held, the payment of the dividend is made out of retained earnings which are lower than the existing stock held.

Furthermore, the issue of a new share would result in higher payment of dividend in cash which is already lower at present

Therefore, it is irrational for a firm to sell a new issue of stock and to pay cash dividends during the same year.