Friday, March 26, 2010


Cost of Equity

Is equity capital free of cost?

It is sometimes argued that the equity capital is free of cost. The reason 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 and 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. The cost of external equity would, however, be more than the shareholders’ required rate of return if the issue prize where difference from the market price of the shares.

In practice, it is a formidable task to measure the cost of equity. The difficulty bribes from two factors;
  1. It is very difficult to estimate the expected dividends.
  2. The future earnings and dividends are expected to grow overtime.

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 computation the cost of internal and external equity are discussed next posts.

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