Cost of Capital: Cost of Common Equity

Capital comes with a cost. Investors demand a certain return on their commitment of capital. If they purchase bonds, they receive interest. If they purchase preferred stock, they receive the preferred dividend. But common equity is tougher. It's a real challenge to try to come up with a method of determining what the "fair" return of common equity should be. This return is typically denoted as $$r_e$$, and expressed in terms of a percentage, such as $$r_e = 9 \% $$.

So you might think of these two options as in the case of Axiom. If Axiom has $1 million in profits, and wants to add $1 million in common equity to their capital structure, they can either pay the $1 million to the owners, and then ask for it back (pay dividends, and then issue new common shares at the same stock price) or just keep the $1 million and reinvest it in the firm (the stock price goes up).

No, that's actually 0.9%.

Yes! That's the idea. The expected return from the investor's standpoint is the cost of capital from the firm's standpoint. This cost can be seen as a measure of risk. There is a positive relationship between risk and return, so when a firm's profits are riskier (or more volatile, more questionable, etc.) then investors will collectively say "hey, I'm going to need more expected return to compensate me for this added uncertainty."

No, that's actually 90%.

So Axiom's cost of equity of 9% would change if they took on more risk by, say, adding more debt. This added debt must be serviced with guaranteed interest payments, and represents leverage to the firm, making it riskier. Which is most likely to be Axiom's new cost of equity if they do this?

You got it!

No, that's a lower cost of equity, representing lower risk. A higher risk level will make investors demand higher risk. So 10% is more likely.

Arriving at an estimate for $$r_e$$ is again a real challenge, and there are a few methods worth exploring, including the Capital Asset Pricing Model (CAPM) approach. The CAPM is basically a line made using both the risk-free rate and the market portfolio in terms of risk and return. Each firm has a calculated beta, which represents market risk. The higher the firm's beta, the higher the cost of common equity. Other methods include using the firm's dividends, price, and assumed growth rate to calculate an estimated required return, or even adding some premium to the issuer's bond yields.

This estimated cost of capital is especially useful if the firm decides to increase its common equity share of capital. There are two main ways of doing this. First, the firm could just issue new common shares. If they are already trading on an exchange, then this new offering can easily be priced. Second, the firm may just reinvest earnings. Axiom doesn't pay dividends, so if it earns a profit of $1 million this year, it has to go somewhere. So it just stays with the firm, which belongs to the owners, and becomes additional equity.

What is the most accurate way for Axiom to think about a dividend payment?

No, consider that a dividend is owner value leaving the firm.

Incorrect. It is a decrease in cash, but remember that Assets = Liabilities + Equity on the balance sheet. A decrease in cash has to be matched by something else.

To summarize this discussion: [[summary]]

If this was the cost of common equity for Axiom Coatings Corp., what is the approximate dollar gain expected by investors purchasing $1,000,000 of common stock?

Yes, absolutely! That equity leaves the company, much as owners of a business taking cash out of their store register.

8%

10%

An increase in common equity

A decrease in cash with no change to common equity

A decrease in common equity

$9,000

$90,000

$900,000

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