Cost of capital (Part I) – Theory and concepts
3. Cost of common equity capital
On first examination, common stock might look like a “free” form of financing. Investors do not receive interest payments and dividends are not legally required. However, there is an implicit cost associated with using equity as a form of financing. As you’ll see below, it often carries a higher price than either debt or preferred equity financing.
A corporation can choose either to use existing retained earnings as a source of funds or to issue new stock. The cost of using retained earnings can be calculated in a number of ways. A simple method is to add a few percentage points to the interest rate of the company’s long-term bonds and call it a day. Although easier on the brain, this is rarely a true reflection of equity’s cost.
A second method is called the capital asset pricing model, or CAPM. The formula is as follows:
K_{c} = K_{RF} + (K_{M} – K_{RF}) x β |
K_{RF} stands for the risk-free interest rate, which is usually found by checking the going rate of Treasury securities. K_{M} stands for the expected rate of return for similar investments. The last term, β, stands for the stock’s beta value. In simple terms, beta refers to how a stock moves relative to the rest of the market -- it’s basically an indicator of risk.
As an example, let’s assume that XY Corporation’s stock has a beta of 0.8, the short-term Treasury bill rate is 4%, and the expected return for similar investments is 11%. The cost of using existing equity would therefore be 4% + (11% - 4%) x 0.8, or 9.6%.
A third method is the dividend yield method, and we can use a form of this method for both existing equity and new stock. The equation for existing equity is below:
K_{C} = (D ÷ P_{0}) + Expected Growth in Earnings |
where D is the next expected dividend and P_{0} is the current stock price.
The cost of issuing new stock is almost exactly the same, except that we need to adjust the denominator for flotation cost per share. Let’s say for example, then, that XY Corporation has a choice between using $960,000 out of retained earnings and issuing 40,000 new shares at a price of $25 while spending $40,000 on legal fees related to the issuance. The current stock price is $25, the next expected dividend is $0.50 per share, and the expected growth in earnings is 7%. If the company uses retained earnings, its cost of common equity is (0.5 ÷ 25) + 7%, or 9%. If the company issues new stock, its cost is (0.5 ÷ 24) + 7%, or 9.08%. ($24 is $25 share price less the flotation cost per share of $1 = $40,000 ÷ 40,000.)
We are now able to figure out a corporation’s cost of debt, preferred equity, and existing or new common equity. What exactly do those numbers mean to upper management, and how do they use the information in their decision-making process? Those are questions we will answer in the second article of this series.