Cost of Equity

11 Key excerpts on "Cost of Equity"

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  eBook - ePub

  Islamic Capital Markets

  Theory and Practice

  • Noureddine Krichene(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Each component of an entity’s capital structure has its unique cost, depending primarily on its respective risk. The cost of capital can be viewed from three different perspectives. On the asset side of a firm’s balance sheet, it is the rate that should be used to discount to a present value the future expected cash flows. On the liability side, it is the economic cost to the firm of attracting and retaining capital in a competitive environment, in which investors (capital providers) carefully analyze and compare all return-generating opportunities. On the investor’s side, it is the return one expects and requires from an investment in a firm’s debt or equity. While each of these perspectives might view the cost of capital differently, they are all dealing with the same number.

  When we talk about the cost of ownership capital (e.g., the expected return to a stock) we usually use the phrase Cost of Equity capital. The Cost of Equity is the rate of return investors require on equity investment in a firm. When we talk about the cost of capital to the firm overall (e.g., the average cost of capital for both equity and debt), we commonly use the term weighted average cost of capital (WACC). The cost of capital applies to both debt and equity investment. Since free cash flow is the cash flow available to all financial investors (debt, equity) the company’s weighted average cost of capital includes the required return for each investor.

  The cost of capital is a function of investment. The true cost of capital depends on the use to which the capital is put; it does not depend on the source of funding. This is the Modigliani–Miller principle, which asserts that the cost of capital for a firm is independent of the source of financing. Each project should, in principle, be evaluated at its own opportunity cost of capital. When a company uses a given cost of capital to evaluate a commitment of capital to an investment or project, it often refers to that cost as the hurdle rate. The hurdle rate is the minimum expected rate of return that the company would be willing to accept to justify making the investment.

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  eBook - ePub

  The Finances of Engineering Companies

  • Alan Reynolds(Author)
  • 2013(Publication Date)
  • Routledge

    (Publisher)

  Past Performance. Another approach to the Cost of Equity is through financial results reported in earlier years. A specific company can be assessed in this way, or one of its business segments, or the entire industrial sector of which it is a part. Several measures of a company’s performance might be selected.

  We start with Earnings, which incorporates both retained profit and dividends. This quantity can be converted into the equivalent of an interest rate by dividing the earnings per share by the market price per share:

  This ratio has the disadvantage of changing as the share price fluctuates, but an average value can be chosen. In its favour, we note that the market price is not an arbitrary accounting quantity, but expresses the cumulative judgement of numerous investors.

  Another way of characterising earnings is through its relationship to shareholders’ funds:

  Although this ratio is commonly called Return on Equity, it may not be the ‘Cost of Equity’ that we hope to find. We have seen (Sections 5.6 and 6.2 ) that SHF is a somewhat arbitrary quantity, strongly influenced by a company’s policies on writing-off and revaluation.

  We can also relate earnings to quantities defining a company’s capital, and specifically to net assets, which is equal to capital employed: This divisor is somewhat better defined, but it may seem perverse to base the return on equity on the sum of equity and loan capital.

  In using any of the proposals of Equations (7.7) to (7.9), we must allow for the tax that is entered in the profit and loss statement before the earnings are struck. This suggests that, for typical rates of taxation, the Cost of Equity may be some 40 per cent higher than the values given by these equations.

  Finally, we might combine the current dividend, which is received immediately, and the anticipated future growth of the company, which can be estimated from past performance. Summing these components, we have

  The present dividend is known, but the second term is less certain. Should it be based on growth in earnings? In turnover? In assets? What period of time should be considered? How do we allow for that part of the growth that comes from the injection of additional capital? For a company with reasonably stable capital and capital structure, the growth in EPS over, say, the past decade might be taken to represent its performance.

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  Corporate Finance

  A Practical Approach

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2012(Publication Date)
  • Wiley

    (Publisher)
• The dividend discount model approach is an alternative approach to calculating the Cost of Equity, whereby the Cost of Equity is estimated as follows:
• We can estimate the growth rate in the dividend discount model by using published forecasts of analysts or by estimating the sustainable growth rate:
• In estimating the Cost of Equity, an alternative to the CAPM and dividend discount approaches is the bond yield plus risk premium approach. In this approach, we estimate the before-tax cost of debt and add a risk premium that reflects the additional risk associated with the company’s equity.
• The marginal cost of capital schedule is a graph plotting the new funds raised by a company on the x -axis and the cost of capital on the y -axis. The cost of capital is level to the point at which one of the costs of capital changes, such as when the company bumps up against a debt covenant, requiring it to use another form of capital. We calculate a break point using information on when the different sources’ costs change and the proportions that the company uses when it raises additional capital:
• Flotation costs are costs incurred in the process of raising additional capital. The preferred method of including these costs in the analysis is as an initial cash flow in the valuation analysis.
• Survey evidence tells us that the CAPM method is the most popular method used by companies in estimating the Cost of Equity. The CAPM is more popular with larger, publicly traded companies, which is understandable considering the additional analyses and assumptions required in estimating systematic risk for a private company or project.
PROBLEMS
1. The Cost of Equity is equal to the: A. expected market return. B. rate of return required by stockholders. C. cost of retained earnings plus dividends. 2. Which of the following statements is correct?