What is Cost of Equity?
Cost of Equity is the shareholder’s required rate of return which makes market value of share equals to expected dividends.
In other words, it is the cost of capital that the company pays to its shareholders for the funds they have provided in the business. Firms may raise equity capital either internally or externally. Internally company raise capital through retained earnings and externally by issuing new shares. In both the cases, shareholders are providing their funds to the company to finance its capital expenditure.
Therefore the rate of return that the shareholder require will be same whether they are going for new shares or forgoing dividends. However, from firm’s point of view, there is difference between retained earnings and issue of equity shares. The firm may have to issue new share at a price which is lower than the market value. While issuing equity, there also involves flotation costs. In other words, raising funds externally is costlier in comparison to raising fund internally.
Is Equity Capital Free of Cost?
Most of the people believes that there is no cost of equity. The arguments for this is that, company is not legally bind to pay dividends to ordinary shareholders. They also say that unlike interest rate or preference dividend rate, the dividend for equity shares is not fixed. It is completely wrong to assume that equity is free of cost.
In reality equity capital involves an opportunity cost. Ordinary shareholders supply fund to the company in the hope that they will get dividends and capital gains that will compensate the risk of investment. Market forces demand and supply determines the market value of the share which represents the return required by the ordinary shareholders.
So, the shareholder’s required rate of return which makes market value of share equals to expected dividends is the cost of capital of equity.
In reality it is very difficult task to measure the cost of equity. The difficulty arises due to two factors –
- It is very difficult to estimate the expected dividends.
- The future earnings and dividends are expected to grow over time.