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The debt-equity ratio is a financial metric that compares the amount of debt a company has with its owners' equity. It is calculated by dividing a company’s total liabilities by its shareholder equity. This ratio provides insight into a company's financial leverage and riskiness, as it shows how much the company is relying on debt to finance its assets.

A debt-equity ratio of 1.20, as seen in Trower Corp.’s case, means that for every dollar of equity, the company has $1.20 in debt. This is a moderate leverage situation which implies the company is taking on more debt than equity, but not excessively so.

When examining a firm’s ability to raise funds for something like a new plant, understanding the debt-equity ratio is critical. It impacts the company’s borrowing capacity and potentially the cost of new debt, given that lenders may offer less favorable terms if they perceive a higher risk due to high leverage.

Equity financing is the process of raising capital through the sale of shares in the company. It is an alternative to debt financing (borrowing money), and it does not come with the obligation to repay a debt. However, when a company issues new shares, it often incurs flotation costs.

Flotation costs are the fees and expenses associated with the issuing of new securities. They include legal fees, underwriting fees, registration fees, and other costs related to the preparation and distribution of the securities. Taking Trower Corp. as an example, every time it raises equity, it must pay an 8 percent flotation cost on the new equity. This reduces the net amount received from issuing new shares and effectively increases the total cost of a project like the new plant.

It's important for companies to account for these costs when planning their financing strategies, as they increase the initial cost of any project funded through external equity. The exercise demonstrates how flotation costs can significantly raise the amount that needs to be funded beyond the raw cost of the plant itself.

Retained earnings represent the accumulated portion of a company’s net income that is not distributed to shareholders as dividends but is retained by the company to reinvest in its business or to pay down debt.

They are a critical source of internal financing because, unlike equity and debt financing, they do not incur flotation costs or interest payments. This makes it an attractive option for companies looking to fund new projects.

In our example with Trower Corp., using 60 percent retained earnings for the new plant means that the company can considerably reduce the amount of money it needs to raise externally, thus dodging expensive flotation costs. This cost-saving approach is reflected in the solution, where we see a lower initial plant cost when leveraging retained earnings versus raising all of the equity externally.

When a company like Trower Corp. finances an entire project with retained earnings, as shown in the third scenario, it completely eliminates flotation costs, offering an unencumbered use of funds at the actual cost of the plant. Therefore, understanding retained earnings is essential for strategic capital management and project financing decisions.