Cost of Common Equity

A firm can raise common equity capital in two main ways:

1. Retained earnings: the company does not distribute all or any of its profits to its shareholders; instead, it retains some or all of them for reinvestment into the business.
2. New common equity: new shares of common stock can be issued.

Both retained earnings and new common equity represent equity positions in the company and, therefore, have fundamentally the same cost because the return required by existing and new shareholders would be the same. One difference between retained earnings and new common equity is that the firm incurs no expense when retaining its own earnings but does incur flotation costs when issuing new shares of common stock.

Cost of Retained Earnings (Existing Common Equity)

The cost of retained earnings to the company is not a cash cost that is paid in the form of dividends or interest. Retained earnings do not earn dividends for stockholders the way outstanding common stock can. Instead, the cost of retained earnings is the opportunity cost of the next best investment that was not made by the firm on behalf of the shareholders.

Retained earnings on the balance sheet increase when all or part of the current year’s net income is not paid out to shareholders in dividends.

By retaining the profits within the company, the firm is investing those profits back into the company on behalf of the existing shareholders. The shareholders will still demand an adequate return on their reinvested earnings. If the shareholders believe the reinvested earnings are not earning an adequate return, they will sell their shares in order to put their investment funds to better use elsewhere. Shareholders who continue to hold the stock are presumably satisfied with the return being earned on the retained profit.

Therefore, the cost of retained earnings is based on the risk of the firm and the investors’ required rate of return. Investors demand a return on their investment in the company whether it is for capital provided by buying new stock or generated by the company’s having reinvested its profits on their behalf.

For example, if the company is generating a 9% return on its assets and the shareholders’ best other alternative investment provides only a 7% return, the shareholders will be happy to have the company retain their profits and invest them at 9%.

However, if the shareholders have another investment opportunity that provides a 12% return, the shareholders would prefer that the company distribute the profits so that they can invest them in the 12% opportunity that is available to them.

Note that the use of retained earnings does not mean that earnings retained from past years’ profits will be used. Retained earnings from past years have already been invested in assets such as property, plant, equipment, and inventories, and thus are not available.

If retained earnings from the current year are not adequate, the company will then issue new common shares.

Models for Calculating the Cost of Retained Earnings

When a company reinvests part or all of its profits back into the organization as retained earnings, management needs to make certain that the shareholders are receiving at least as much return on the reinvestment of the retained earnings as they would have received if they had been given that money and invested it in their choice of investments.

In order to assess shareholder return, the company needs to measure the cost of its retained earnings. The cost of retained earnings can be measured using:

1. The Dividend Growth Model (restated) is used when dividends are paid, and
2. The Capital Asset Pricing Model (CAPM) is used when no dividends are paid.

Cost of New Common Equity

The Dividend Growth Model is used to calculate the cost of retained earnings when the company pays a dividend that is expected to grow in the future. The same formula can be used with only a slight modification to determine the cost of newly issued common stock when a dividend is paid that is expected to grow.

The cost of new external common equity is higher than the cost of retained earnings because registering and selling the new stock has costs. The costs are called flotation (issuance) costs and they need to be factored into the calculation of the cost of new shares. Furthermore, firms find it more expensive to raise money through the issuance of shares than through the issuance of debt because the shareholders will require an additional return to compensate them for the additional risk of owning equity instead of debt.

Thus, the formula to determine the cost of newly-issued common stock uses the net proceeds of the newly issued stock instead of the price of the stock.

Cns  =	D1	+	G
	Pn

Where:

Cns ⇒ Cost of the new issuance of common stock, expressed as a percentage

D1 ⇒ The next dividend to be paid per share (the previous annual dividend multiplied by [1 + the annual expected % growth rate in dividends] if the anticipated dividend is not given)

Pn ⇒ Net proceeds of the issue per share (selling price minus issuance costs)

G ⇒ The annual expected % growth rate in dividends (if the dividends are not expected to grow, this value is 0)

Note that the denominator when calculating the cost of newly issued common shares is equal to the net proceeds of the issuance of the shares. This is the same as it was for the calculation of the cost of newly issued preferred shares.

The net proceeds are equal to the market price of the shares minus the flotation costs.

Like the formula used to calculate the cost of retained earnings (existing common equity), the above formula also assumes that the dividend will increase by the same percentage each year.