Final answer:
Retained earnings are increased by net income, making Option 3: Net income correct, as retained profits contribute to a company's retained earnings. Dividends reduce retained earnings, while issuing common stock and additional paid-in capital are equity transactions and do not affect retained earnings directly.
Step-by-step explanation:
Retained earnings refer to the portion of net income that is retained by a company rather than distributed to its shareholders as dividends. Therefore, when comparing the options given, Option 3: Net income is the one that increases retained earnings. Firms can use retained earnings as a source of financial capital, reinvesting those profits back into the business for growth and development. This can include purchasing new equipment, constructing facilities, or funding research and development efforts.
On the other hand, Option 1: Dividends reduce retained earnings because they represent a distribution of profits to shareholders. Option 2: Common stock and Option 4: Additional paid-in capital represent equity financing but do not directly affect retained earnings since they are transactions with shareholders and involve the issue of new shares, not the distribution of earnings.