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Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new share. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return would be the same whether they supply funds by purchasing new share or by foregoing dividends, which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to also; it may have to incur flotation costs. Thus external equity will cost more to the firm the internal equity.

Is equity capital free of cost?

It is sometimes argues that the equity capital is free of cost. The reason for such argument is that it is not legally binding for firms to pay dividends to ordinary shareholder. Further, unlike the interest rate or preference dividend rate, the requital to be free of cost. As we have disused earlier, equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dives’s the market value of the share in the expectation of dividends and capital gains commensurate with their risk of investment. The market value of the share determined by the demand and supply forces in well functioning capital market reflects the return required by ordinary, shareholder. Thus. The shareholder’s repaired with the return, which equates the present value of the expected dividends with the market enquiry would, however be more than the shareholder’s market pried of the share.

In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factored. First, it is very difficult to estimate are expected to grow over time growth in dividends are expected and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task.