What is the implication of using retained earnings for a firm's internal equity?

Using retained earnings as a source of a firm’s internal equity implies that the company is opting to reinvest its profits back into the business rather than distributing those profits to shareholders as dividends. This approach is often regarded as a "free" source of capital because it does not require the company to go into the financial markets to raise new equity, which can involve issuing new shares and potentially incurring significant costs, such as underwriting fees and dilution of existing ownership.

Furthermore, since retained earnings consist of profits that have already been taxed, companies do not face immediate additional tax liabilities when reinvesting these funds, unlike when they might raise money through debt (which comes with interest costs) or issue new equity. Therefore, retained earnings can be seen as a cost-effective option for financing growth and expansion, allowing for the reinvestment of capital without incurring external financing charges.

This understanding of retained earnings reinforces the financial strategy of companies that prefer to leverage their existing resources, minimizing outside funding costs and maintaining greater control over their operational finances.