| Firms may raise equity capital internally by retaining | | | | expected dividends with the market value of the |
| earnings. Alternatively, they could distribute the entire | | | | share, is the cost of equity. The cost of external |
| earnings to equity shareholders and raise equity | | | | equity would, however, be more than the |
| capital externally by issuing new shares. In both | | | | shareholders' required rate of return if the issue prize |
| cases, shareholders are providing funds to the firms | | | | where difference from the market price of the |
| to finance their capital expenditures. Therefore, the | | | | shares. |
| equity shareholders' required rate of return would be | | | | In practice, it is a formidable task to measure the |
| the same whether they supply funds by purchasing | | | | cost of equity. The difficulty bribes from two |
| new shares or by foregoing dividends, which could | | | | factors; |
| have been distributed to them. There is, however, a | | | | 1. It is very difficult to estimate the expected |
| difference between retained earnings and issue of | | | | dividends. |
| equity shares from the firms point of view. The firm | | | | 2. The future earnings and dividends are expected to |
| may have to issue new shares at a price lower than | | | | grow overtime. |
| the current market price. Also, it may have to incur | | | | Growth in dividends should be estimated and |
| flotation costs. Thus, external equity will cost more | | | | incorporated in the computation of the cost of |
| to the firm than the internal equity. | | | | equity. The estimation of growth is not an easy task. |
| Is equity capital free of cost? | | | | Keeping these difficulties in mind, the methods of |
| It is sometimes argued that the equity capital is free | | | | computation the cost of internal and external equity |
| of cost. The reason for such argument is that it is | | | | are discussed next posts. |
| not legally binding for firms to pay dividends to | | | | The cost of retained earnings determined by the |
| ordinary shareholders. Further, unlike the interest rate | | | | dividend valuation model implies that if the firm would |
| or preference dividend rate, the equity dividend rate | | | | have distributed earnings to shareholders, they could |
| is not fixed. It is fallacious to assume equity capital to | | | | have invested it in the shares of the firm or in the |
| be free of cost. As we have discussed earlier, equity | | | | shares of other firms of similar risk at the market |
| capital involves an opportunity cost; ordinary | | | | price (Po) to earn a rate of return equal to equity |
| shareholders supply funds to the firm in the | | | | cost. Thus, the firm should earn a return on retained |
| expectation of dividends and capital gains | | | | funds equal to cost of equity to ensure growth of |
| commensurate with their risk of investment. The | | | | dividends and share price. If a return less than cost |
| market value of the shares determined by the | | | | of equity is earned on returned earnings, the market |
| demand and supply forces in a well functioning capital | | | | price of the firms share will fall. It may be |
| market reflects the return required by ordinary | | | | emphasized again that the cost of returned earnings |
| shareholders. Thus, the shareholders' required rate of | | | | will be equal to the shareholders' required rate of |
| return, which equates the present value of the | | | | return since no flotation costs are involved. |