Cost Of Equity Share Capital
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COST OF EQUITY SHARE CAPITAL
The holders of equity shares are the residual owners of the firm and provide long terms funds expecting to be rewarded with an increase in the economic value of the share. This value comprises the interlocking effects of growing earnings, growing dividends and the market value of the share, which in tern is affected by the risks specific to the industry and to the individual firm.
The measurement of cost of capital of equity share capital is far by the most typical and conceptually a difficult exercise. The reason being that there is no coupon rate in case of equity shares. In case of cost of capital of debt and preference share capital, the rate of interest and the rate of dividend were the starting point respectively. However, no such starting point is available for cost of equity share capital. Further, there is no commitment to pay equity dividend and it is the sole discretion of the board of directors to pay or not to pay dividend or to decide at what rate the individual be paid to the equity shareholders. Moreover, the equity shareholders are the last claimant on the profits of the company. Therefore, it is often said that the equity shares have no cost of capital as such. But like preferences share capital, it is not true for equity share capital also.
Equity share capital, like other sources, also has a cost. Just as in the case of debt and preferences shares, the investors will invest the funds in the form of equity share capital of a firm only if they expect a return from the firm, which will compensate them for surrendering the funds as well as the risk undertaken. It may be noted that, in case of debt and preferences share capital, the return from the firm was known in the form of coupon rate but in case of equity share capital, the investor must be able to find out the expected rate of return from the firm. The return in case of equity share is available basically, ion the form of dividends from the firm. Therefore, the potential investors of equity share capital must estimate the expected stream of dividend from the firm. This stream of dividend may then be discounted to get the present value of such stream. The rate of discount at which the expected dividends are discounted to determine their present value is known as cost of equity share capital.
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The measurement of cost of capital of equity share capital is far by the most typical and conceptually a difficult exercise. The reason being that there is no coupon rate in case of equity shares. In case of cost of capital of debt and preference share capital, the rate of interest and the rate of dividend were the starting point respectively. However, no such starting point is available for cost of equity share capital. Further, there is no commitment to pay equity dividend and it is the sole discretion of the board of directors to pay or not to pay dividend or to decide at what rate the individual be paid to the equity shareholders. Moreover, the equity shareholders are the last claimant on the profits of the company. Therefore, it is often said that the equity shares have no cost of capital as such. But like preferences share capital, it is not true for equity share capital also.
Equity share capital, like other sources, also has a cost. Just as in the case of debt and preferences shares, the investors will invest the funds in the form of equity share capital of a firm only if they expect a return from the firm, which will compensate them for surrendering the funds as well as the risk undertaken. It may be noted that, in case of debt and preferences share capital, the return from the firm was known in the form of coupon rate but in case of equity share capital, the investor must be able to find out the expected rate of return from the firm. The return in case of equity share is available basically, ion the form of dividends from the firm. Therefore, the potential investors of equity share capital must estimate the expected stream of dividend from the firm. This stream of dividend may then be discounted to get the present value of such stream. The rate of discount at which the expected dividends are discounted to determine their present value is known as cost of equity share capital.
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