Cost of Equity: Why Shareholders Expect a Return

Imagine you are deciding to invest your hard-earned money. You have a few options. You could put it in a very safe government bond, or you could buy shares in a company. Choosing to buy shares, to become a shareholder, is inherently riskier than choosing that safe bond. Share prices can go up and down, the company might not perform well, and there’s always a chance, however small, of losing your investment.

From a shareholder’s perspective, the cost of equity represents the minimum return they expect to receive for taking on this risk of investing in a particular company’s stock. It’s essentially the price the company must pay to use the shareholder’s money. Think of it like renting money. When a company wants to use debt, it has to pay interest to the lenders. Similarly, when a company uses equity financing, meaning they issue shares, they have to provide a return to the shareholders. This expected return is the cost of equity.

Why is it a ‘cost’? Because if the company doesn’t deliver a return that is at least as good as the cost of equity, shareholders might decide to sell their shares and invest elsewhere, perhaps in a different company or even back into those safer government bonds. This selling pressure can then negatively impact the company’s stock price, making it harder for the company to raise capital in the future and potentially hindering its growth.

So, what factors influence this cost of equity? A key factor is risk. If a company is considered very risky, perhaps it’s in a volatile industry or has a lot of debt, shareholders will demand a higher return to compensate for that increased risk. It’s like asking for a higher interest rate if you are lending money to someone with a shaky financial history. On the other hand, a stable, well-established company in a predictable industry might have a lower cost of equity because it’s seen as less risky. Shareholders are still expecting a return, but they might be satisfied with a lower percentage because the risk is perceived to be lower.

Another important element is opportunity cost. Shareholders always have alternative investment options. They could invest in other companies, real estate, or again, those government bonds. The cost of equity must be high enough to attract and retain shareholders, making investing in this particular company more appealing than those other alternatives, considering the level of risk involved. If the potential return from a company’s stock is too low compared to other opportunities with similar risk profiles, shareholders will likely choose to invest elsewhere.

In essence, the cost of equity is the shareholder’s required rate of return. It’s the benchmark that shareholders use to evaluate whether investing in a company is worthwhile. Companies strive to keep their cost of equity manageable because a lower cost of equity makes it easier and more attractive to fund projects, grow their business, and ultimately increase shareholder value. It’s a vital metric that reflects the expectations and required compensation of those who own a piece of the company – its shareholders. Understanding the cost of equity from a shareholder’s perspective is crucial to grasp the dynamics of corporate finance and investment decisions.