Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than, the internal equity.
Is Equity Capital Free of Cost?
It is sometimes argued that the equity capital is free of cost. The reasons for such argument is that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to be free of cost. As we have discussed earlier equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dividends (including capital gains) commensurate with their risk of investment. The market value of the shares determined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus the shareholders required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity capital. The cost of external equity could, however be different from the shareholders required rate of return if the issue price is different from the market price of the share.
Estimating the Cost of Equity Capital
In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors: First, it is very difficult to estimate the expected dividends. Second, the future earnings and dividends are expected to grow over time. Growth in dividends should be estimated and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task. Keeping these difficulties in mind, the methods of computing the cost of internal and external equity are discussed below.
Cost of Internal Equity
The opportunity cost of the retained earnings (internal equity) is the rate of return on dividends foregone by equity shareholders. The shareholders generally expect dividend and capital gain from their investment. The required rate of return of shareholders can be determined from the dividend valuation model.
According to dividend-valuation model, the cost of equity is thus, equal to the expected dividend yield (D/P0) plus capital gain rate as reflected by expected growth in dividends (g).
ke = (D/P0) + g
It may be noted that above equation is based on the following assumptions:
- The market price of the ordinary share (
Po) is a function of expected dividends.
- The initial dividend, D is positive (i.e. D > 0).
- The dividends grow at a constant rate g, and the growth rate (g) is equal to the return on equity (ROE) times the retention ratio (b) (i.e. g = ROE x b).
- The dividend payout ratio (i.e. (1 – b)) is constant.
The cost of retained earnings determined by the dividend valuation model implies that if the firm would have distributed earnings to shareholders, they could have invested it in the shares of the firm or in the shares of other firms of similar risk at the market price (
In addition to its use in constant and variable growth situations, the dividend valuation model can also be used to estimate the cost of equity of no-growth companies. The cost of equity of a share on which a constant amount of dividend is expected perpetually is given as follows:
ke = (D/P0)
Cost of External Equity
The minimum rate of return, which the equity shareholders require, on funds supplied by them by purchasing new shares to prevent a decline in the existing market price of the equity share is the cost of external equity. The firm can induce the existing or potential shareholders to purchase new shares when it promises to earn a rate of return equal to:
ke = (D/P0) + g
Thus, the shareholders required rate of return from retained earnings and external equity is the same. The cost of external equity is, however, greater than the cost of internal equity for one reason. The selling price of the new shares may be less than the market price. In
ke = (D/ Io) + g
Where Io is the issue price of new equity. The cost of retained earnings will be less than the cost of new issue of equity if