The cost of capital Equity versus Debt

Question

Trying to understand something basic about cost of capital that I can't seem to wrap my head around.

When we talking about issuing debt to raise funds for a project, the cost of capital is the interest the company pays on what they borrowed relative to what the undertaking may earn, but when a company issues shares it receives money from investors but doesn't actually pay the investor anything (excluding dividends which a company may not pay). For an investor to get their money, they have to sell what they bought on the secondary market and not back to the company itself. In what sense does issuing equity "cost" the issuer anything?

Answer 1

First, remember that a company is owned by its investors - it is not owned by 'itself'. It is true that a company might choose not to always pay dividends, but that is a decision which should benefit the owners not the company itself.

So while dividends are not mandatory, the owners of the company have an opportunity cost they suffer by continuing to own shares, when instead they could liquidate the company [in theory] and put funds elsewhere. More realistically, if a company doesn't earn enough to compensate owners for the risk of ownership, they will sell to others, for lower and lower prices, until new owners are satisfied that their [now smaller] investment amount is appropriately compensated company earnings.

So when a company views the profitability of a new project, it should consider whether it will (a) pay an appropriate portion of the company's overall debt servicing costs [interest]; AND (b) pay an appropriate portion of the return required on equity given the assessed risk level of the business. If a new project earns less than (a) + (b), then it is theoretically better from a corporate finance perspective to just pay out the investment amount as a dividend instead.

Note that the cost of equity is not purely the amount of dividends paid - even non-dividend paying companies consider a cost of equity, which again reflects the opportunity cost taken by owners of the company to hold shares. There are many levels of attempted 'accuracy' at assessing what the cost of equity is for a business, and in some cases it may be taken as a simple rule of thumb for that industry - something like 'if debt cost is 3%, we should anticipate equity cost to be 10%'. That rate is then used to assess whether new projects actually 'pay for themselves', in the eyes of shareholders.

Answer 2

The cost of existing equity is the opportunity cost of retained earnings. The company can either dividend out its earnings (or part of them) or retain them. If it retains them, it has to "compensate" the investor for foregone opportunities by investing in activities that earn as much or more than the investors could have earned on their own. There are various ways in the finance field to determine the investors' required returns on the company's stock, and that is what is used to determine the cost of equity to the firm.

The self-correcting mechanism in this is that if the company's value (and its stock value) is not yielding the required return, investors will sell and the stock price will fall until it is low enough for the value generation the firm is delivering to at least yield the required return.

Answer 3

It's really the "cost" of issuing new equity that is being considered. When you sell equity, you are selling a fraction of ownership of the company - meaning rights to assets in the event of a sale or liquidation, and to dividends in the future. A very simple view of the cost of shares is "expected return", meaning what return do I expect to get on these shares in the future. That return comes from the growth of the company over time (dividends are not really "return" since it reduces the value of the company by the same amount).

So when a company wants to finance a new project, for example, and doesn't want to (or can't) use capital it already has, it can either borrow it (where the "cost" is the interest rate), or it can sell equity, where the "cost" is the expected rate of growth that it's selling.

Put another way, if the company did not sell equity, and instead used funds it already had, it would be able to "keep" that growth rather than the shareholders having a right to it (technically the existing shareholders would have a right to it, but depending on how you bucket things it illustrates the "cost" of the funds that you raised through equity).