Unlike debt and preferred stock, cash flows from common equity are not fixed or known beforehand, and their risk is harder to evaluate. In addition, firms have two sources of common equity – retained earnings and new stock issues – and thus two costs of common equity. It may be clear that there is an explicit cost (i.e., dividends and flotation costs) associated with issuing new common equity. But while the firm pays no extra dividends or flotation costs to use retained earnings, their use is not free; we must consider the opportunity cost of using money that could have been distributed to shareholders. Retained earnings represent the portion of net income that the firm does not distribute as dividends. From the shareholders’ perspective, the opportunity cost of retained earnings is the return the shareholders could earn by investing the funds in assets whose risk is similar to that of the firm. To maximize shareholder wealth, management must recognize that retained earnings have a cost. That cost, kre, is the return that shareholders expect from their investment in the firm.