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
shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return will be the same whether they supply funds by purchasing new shares 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 issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than the internal equity.
Is Equity Capital Free of Cost?
It is sometime argued that the equity capital is free of cost. The reasons for such argument are that it is not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest rate or preference dividend rate, the equity dividend rate is not fixed. It is fallacious to assume equity capital to be free of cost. As we have discussed earlier, equity capital involves an opportunity cost; ordinary shareholders supply funds to the firm in the expectation of dividends (including capital gains) commensurate with their risk of investment. The market value of the shares deter-mined by the demand and supply forces in a well functioning capital market reflects the return required by ordinary shareholders. Thus, the shareholders’ required rate of return, which equates the present value of the expected dividends with the market value of the share, is the cost of equity. The cost of external equity could, however, be different from the shareholders’ required rate of return if the issue price is different from the market price of the share. In practice, it is a formidable task to measure the cost of equity. The difficulty derives from two factors: First, it is very difficult to estimate the expected dividends Second, the future earnings and dividends are, expected to grow over time. Growth in dividends should be estimated and incorporated in the computation of the cost of equity. The estimation of growth is not an easy task.