Cost of equity is the cost incurred by the company to meet the rate of return expected by investors, either in the form of dividends or capital gains. Since investors expect a rate of return on the investment, a company should compensate the shareholders with the economic returns. This must be implicit in forecasting the future, which has to be different from the previous performance. The company's incapability in controlling the cost of equity can increase the occurrence of financial distress, which in turn can decrease the firm's value (The Influence of Cost of Equity on Financial Distress and Firm Value by Anna Sumaryati, Nila Tristiarini).
Cost of equity is the cost incurred by the company to meet the rate of return expected by investors, either in the form of dividends or capital gains. Since investors expect a rate of return on the investment, a company should compensate the shareholders with the economic returns. This must be implicit in forecasting the future, which has to be different from the previous performance. The company's incapability in controlling the cost of equity can increase the occurrence of financial distress, which in turn can decrease the firm's value (The Influence of Cost of Equity on Financial Distress and Firm Value by Anna Sumaryati, Nila Tristiarini).
Company value is very important because it reflects the success in maximising goals; this is indicated by increasing prosperity for investors. Company goals are clearly planned. Company value as a proxy reflects shareholder wealth. The value of the firm can give maximum shareholder wealth if the stock price increases. The more increase in the stock price of a company, enhanced is the shareholder wealth also.
The firm value is subject to many internal and external influences; however, for this piece, I will restrict to the mere evaluation of the impact upon the entity, based on the cost of equity.
The cost of equity is used for the analysis and valuation of the company. It elaborates the rate of return required by an investor so that they will be inclined towards investing their funds in the company (Johnson, 2021).
Capital Asset Pricing Model (CAPM) is one of the most important methods that businesses use to calculate their cost of equity or to measure the required rate of return. CAPM has many advantages like; it captures systematic risk; verified by empirical research; considered a superior method of calculating the cost of equity, better than the dividend growth model; and it is also considered superior than the WACC in investment appraisal.
However, the opposite view is that the equity risk premium is volatile and changes rapidly; and the calculation of betas is extremely difficult.
The most common equity costing models are:
CAPM; this method measures the relationship between systemic risk and the rate of return of the asset/stock. Cost of Equity = Risk-Free Rate of Return + * (Market Rate of Return – Risk-Free Rate of Return) eg a Company X in the S&P 500 is evaluated through the CAPM model as;
• Market Rate of return = 10 percent
• Risk-free rate = 1 percent
• = 1.1 ( >1 ie slightly more sensitive than the market).
Using the CAPM method in this case the cost of equity is = 1 percent + 1.1 * (10-1) = 10.9 percent.
Weighted Average Cost of Capital (WACC); is another important method of evaluating cost of equity and cost of debt. Here, the WACC is = (E/V×Re) + (D/V×Rd×(1 Tc)) where:
E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E+D = Firm’s Value
Re = Cost of equity
Rd = Cost of debt
Tc = Corporate tax rate (Seth, 2021)
This evidences that the total cost of any firm is the weighted average between cost of debt and cost of equity. This methodology is also beset with its own merits and demerits. While it is a simple and easy calculation; the comparison between various projects is easy, and involves fast decision making. The demerits are: the assumption of no change in capital structure is impractical: the assumption of no change in risk profile is unrealistic, and the cost of trade credit is ignored.
In order to finance its projects and working capital, the businesses have two options: equity financing, and debt financing.
Equity financing can be conducted through sponsor’s capital or inviting general public to invest in the company through IPO. The most important benefit of equity financing is that principal and interest payments are not required. Hence there is no adverse impact on profitability of the business. Dividend payments are made as per the desire of the management. However, the most crucial disadvantage of equity financing is the dilution of ownership. A very high cost of equity can also lead to financial distress in the company. (Anna Sumaryati, 2018)
In Debt Financing, debt may be raised from banks and financial institutions without dilution of ownership. Secondly, in high tax rate environment, debt financing reduces the burden of tax also. The most important disadvantage of debt financing is repayment of principal and interest which puts a burden on cash flow.
The capital structure theory explains the effect of capital structure on firm value. Company value can be interpreted as an expectation of shareholder investment value (equity market price) and/or expectation of total company value (equity market price added with a market value of debt, or market price of asset expectation).
While Hasnawati, Sri, “Dampak Set Peluang Investasi Terhadap Nilai Perusahaan Publik di Bursa Efek Jakarta, in the ”Jurnal Akuntansi dan Auditing” Indonesia, prove in their paper, that Cost Of Equity directly affects the value of the company and indirectly the investment decision affects the value of the company through dividend policy and funding decision.
Cost of equity is determined by dividends and share price impact of which are explained as; companies that will pay a higher amount of dividends will end up with less free cash flow for re-investment. Dividend growth rate is generally kept stable by the companies otherwise it will put pressure on the cash flow of the business. A higher share price may satisfy investors but it comes with the caveat of higher cost of buy-back. Furthermore, it would reduce the dividend yield going forward.
Investors aim to maximise the return on their investment. Therefore, firms must strive to maintain and increase its profitability. If the return provided by the firm ie cost of equity is not greater than the cost of capital, the investors will withdraw their investment and switch to other avenues (Sattar, 2015). According to cited research in case of Pakistan, the firms should maintain its cost of capital and increase its size in order to satisfy the investors.
However, there are other studies wherein the capital structure (cost and allocation of equity and debt) doesn’t have a significant impact on the value of the firm. Other qualitative factors like quality of management, economic and political conditions, role of bulls and bears, government policies, etc are also important. (Boora, 1996)
Cost of equity can affect financial distress and firm value. The utilisation of cost of equity can be used for shareholders to measure a manager's performance in maximising shareholder's profit. Cost of equity is an important measure of the value of the firm. It can be assessed through CAPM and WACC and both of these methods have their own advantages and disadvantages.
Firms can finance their expansion and working capital through debt financing or equity financing based on the market situation. The business receives the impact of cost of equity.
Through high dividends, its cash flow diminishes and with higher share price, cost of buyback rises, and dividend yield falls. However, the investor would only stay attached to the firm if the cost of equity is greater than cost of capital. Otherwise, the investors will move to other shares.
The writer is a senior banker and a freelance columnist
