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Dear Sir,
Maybe a stupid question, but I still can not convince myself.
They always say that the equity cost is most expensive. But I think a company never need to repay its shareholder, not like debt holder, the interest payment are really cash outflow yearly. Even if the company goes bankruptcy, its shareholders still have the latest right for claiming their rights on company’s net asset if any remained. I can’t see any cost which is really paid out, except the issuing fee of shares. So I even think equity is cheapest capital comparing with debt
So could you please give a brief clarification on this question, or a refutation on my point?
Thanks for your time.
But shareholders will be expecting a return from the company (dividends).
If the company is not giving shareholders the return that they require then the company will not be able to raise more equity finance – people will only buy shares in a company if they expect to receive a decent return.
The return may be in terms of dividends and/or increase in market value (although in theory the two are the same because it is the expected dividends that determine the market value).
If a company is not earning an adequate return on investments then dividends will suffer and the share price will fall.Shareholders will demand a higher return than debt lenders because their investment is more risky – debt lenders are guaranteed fixed interest each year (provided the company does not go bankrupt) whereas the return to shareholders is not guaranteed (the profits may be higher than expected but equally they may be lower than expected – i.e. more risky)
Dear Sir, thank you for your reply.
Regarding the dividend, a company always has the right on deciding when and how much they will be paying the dividend, even not paying. I mean dividend is always NOT compulsory comparing with debt interest payment. Also shareholders investment return can come from the increase on the share price itself even when company is not paying out dividend or paying very little.
Thus, at least during the period before a company’s share price goes down (not really all the time actually in market), if the company is not paying dividend, then there will be no cost on using equity capital, at least during that period.
Am I correct?
Thank you again for your time.
You are correct that the company can decide what dividend they pay – they do not have to pay a dividend.
However, assuming they are making profits, then if they do not pay a dividend this year then the money will be reinvested to expand the company and make bigger profits (and be able to pay more dividends) in the future.
The market value of shares is based on the expected future dividends.
When we calculate the cost of equity, we are trying to estimate the cost of raising future shareholder finance. The money from existing shares will already have been invested – what we are trying to do it estimate the cost of raising more money from shareholders. The only way we can do this is by looking at the existing shares, seeing how much shareholders are prepared to pay for them on the stock exchange, estimating what future dividends shareholders are expecting. We then determine what return shareholders want for them to be prepared to buy existing shares on the stock exchange.
So, a baby example, suppose the exisiting shares have a market value of $2.00 on the stock exchange and shareholders are currently expecting there to be a constant dividend of $0.20 per year. If they are prepared to pay $2.00 on the stock exchange they must be wanting the return to be 10% per year (0.20/2.00). If they wanted a higher or lower return then they would be prepared to pay less or more for the share on the stock exchange.
So…….since they want 10% if they are to buy existing shares on the stock exchange, we assume that if we want to raise more finance by shareholders (either by issuing more shares or retaining earnings instead of paying it to them as a dividend) then the company is going to have to be able to give them at least 10% return on the new finance raised.
Because of the above, the cost of equity will never be zero. They would mean that the company could raise more money from shareholders without giving them any return in the future, which would simply not be possible.
I hope that makes sense, but if you have not watched my lecture on this then it is worth watching them. There are lecture linked from the P4 page (and also linked from the F9 page – the early P4 lectures are more revision of F9 on this topic).
Thank you sir for your replies.
But I do NOT think that all companies will ALWAYS in need of future money. For a theoretical example, if a company only raises equity capital one time, and will never raise more money in future because they are operating very successfully, and can satisfied by own funds instead of paying too much dividend, thus their capital cost should be very little or even zero if no dividend paid.
On the other hand, could I just think that the equity capital cost is actually only the expectation of potential investment return from shareholders, And this expectation urges the company should to operate their business very effectively and successfully, otherwise they will not be able to raise future money if they need. But I still think if they are not raising future money and when they are not paying dividend, the equity cost should be zero.
Thanks for your time.
Not paying out all the earnings as a dividend is raising money from shareholders!!
It is the most common way that companies raise finance.
Shareholders are entitled to the earnings. If some of the earnings are held back in order to expand the company, then shareholders will demand a return on it.
The cost of equity will never be zero.
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