The higher the firm's flotation cost for new common equity,the more likely the firm is to use preferred stock,which has no flotation cost,and retained earnings,whose cost is the average return on assets.

Flotation costs are associated with issuing new securities and can apply to both common and preferred stock. Retained earnings are considered a cost-effective source of financing, not because their cost is the average return on assets, but because they do not involve direct issuance costs and are internally generated.