First, a word about “Internal” and “External Funds,” and “Flotation Costs” – before we use these notions on the ensuing pages. We discussed Internal and External Funds earlier, so the reader is referred to the page entitled: “External Funds Needed Formula.” (“CTRL-F” it in order to find it in this text’s PDF form. It is again discussed in depth further below.)

A company needs capital (right-hand side of the balance sheet), or funds, in order to finance its assets (left-hand side). It needs assets in order to produce sales and, hopefully, profits. No assets, no production. Some of the needs for funds will be provided internally.

External funds are those (capital-) funds, which the company must access from “outside” the company’s normal business activities; external funds are acquired in order to supplement any deficiencies that are likely to occur when funds generated from operations are insufficient for fueling growth in sales and profits, which require the use of additional assets. External Funds may include borrowings or new Equity capital. This may occur in the case of a start-up that has sparse cash flow or in the instance of a company experiencing a downturn in its business. Acquiring external funds is not something a company does routinely.

External Funds include borrowed money (i.e., debt), and preferred and common stock. There are economic costs associated with external funds, each of which costs will be reviewed on the next pages formulaically. Internal funds, for the present purposes, will be limited to Retained Earnings, although Accounts Payable are also considered to be internal.

Regardless of the source of the funds, whether internal or external, they all have economic costs, not to be defined necessarily as accounting “expense,” although that may also pertain. Thus, interest on debt is an expense in that it reduces net income, but dividends are merely “expenditures,” paid out from net income. Dividends are not expenses. The acquisition of fixed assets is a capitalized expenditure, not an expense. All are nevertheless economic costs.

An economic cost may also be thought of as an “opportunity cost”; for instance, if one owns stock, he will sell it if his return does not meet with the expected return on a reasonable alternative. Thus, external funds have explicit costs, i.e., interest on debt, dividends on stock, but may also have implicit, opportunity costs. Common Stock, for example, has another, a second, opportunity cost – growth in dividend and price.

If the investor demands, or “requires,” growth in dividends and price – because of his opportunity set, the firm must deliver it. The return that an investor requires on his investment due to his opportunity cost becomes the firm’s economic cost as well. If the common stock investor is unhappy with his overall return, including growth, s/he will sell the stock or, perhaps worse, vote out the management and directors when the next proxy comes around. If the investor “requires” a certain return, the firm must deliver.

Now, Flotation Costs are the costs associated with paying Investment Bankers, Accountants, Lawyers, and other advisors their fees for assisting the corporation in raising external funds – debt, and preferred and common stock. We will assume that the Flotation Costs for debt and preferred shares are virtually nil, since these capital sources are usually sold to large corporate/institutional investors in sizable allotments. However, as common shares are usually sold to small investors in small amounts, substantial marketing is involved and therefore more banking fees, or Flotation Costs, pertain. Flotation Costs, again, are the costs associated with “floating” the issue.

There is no cost to retaining earnings; ya just do it! So, internal equity is cheaper than external equity because there are no Flotation Costs. It is within the firm’s normal course of doing business that it keeps some – or all – of its profits in the corporation so that it will have funds for investment in growth opportunities – as opposed to paying them out to shareholders as dividends.