Correct Answer:
D. Retained earnings
The cost of capital is the rate of return a company must earn on an investment to maintain its market value. Different financing sources have varying costs. Retained earnings are generally considered the cheapest source of capital. This is because they avoid explicit flotation costs (fees paid to investment bankers for issuing new securities) associated with new equity. While there is an opportunity cost (the return shareholders could earn elsewhere), it's often lower than the cost of issuing new shares.
- Equity (new common stock) is typically the most expensive due to high flotation costs and the highest risk for investors.
- Debt has interest payments and financial risk, but its after-tax cost is usually lower than equity.
- Preference shares have fixed dividends and are generally more expensive than debt but less than common equity.