The cost of equity capital is the amount of compensation a company must pay when issuing stock to pay for business projects. The cost of equity capital is a bit more complex than the cost of debt; the latter’s cost is directly tied to the interest rate for money loaned to the company. The biggest factors for the cost of equity include the dividends per share paid by the company, the current market value, and the dividend growth rate. Each of these pieces of information is necessary to compute the cost of equity. As the information dictates, only publicly held companies need this formula for this process.
Dividends per share represent the current amount of money a company pays shareholders for each piece of stock held by investors. They are immediate financial returns paid to investors who “loan” money to the company. Companies who pay out large dividends early on may affect their cost of equity capital in the future. In most cases, preferred shares of stock most likely receive dividends as rewards for investing money into the company. Common stock shares typically get voting rights in lieu of dividends; therefore, common stock dividend information may not exist in a company’s accounting information.
A company’s current market value of preferred shares is the denominator in the initial calculation for the cost of equity capital. High market share value tends to indicate that investors are quite willing to invest into a company. Therefore, a company’s preferred shares with low supply and high demand can result in these high prices. Companies that continue to liquidate the value of preferred shares through constant stock issuance can affect their future cost of equity capital. In some cases, this is why companies only reissue common stock with voting rights as preferred shares are only issued when more money is needed for major business projects.
The last factor that can greatly affect a company’s cost of equity capital is the dividend growth rate expected for preferred shares. This growth rate indicates the amount of money a company will continue to pay out to investors holding preferred shares. Some companies may decide to keep the dividend growth rate small yet stable. Other companies may have so much cash that they need to reduce the balance at some point. Paying out higher dividends to preferred stock shareholders can help lower the cash balance while affecting the company’s cost of equity capital.