Businesses use a combination of equity and debt to finance their operations. Unlike debt finance, equity finance does not incur an interest cost, the cost of equity financing arises from the fact that part of the ownership of the business is sold in return for investment, and a percentage of the profits now belongs to the investor shareholder.
Investors in common stock of a business will look for a higher return than providers of debt finance, as their return comes from the profits of the business after interest payments have been deducted and lenders have been paid. Ultimately, in the event of a bankruptcy, the investors are the last to be paid out, and their return and therefore the cost of equity will be higher as a result.
How to Calculate Cost of Equity
Unlike the calculation for the cost of debt finance, the cost of equity cannot be based on a predetermined interest payment, as investors are not guaranteed a set return over a specified term.
As previously stated, the cost of obtaining equity investment in a business results from having to relinquish a percentage of the profits to an outside investor. The investor will receive a return on their investment by way of dividends from the business, and by gains they make when they sell their investment.
Most startup businesses have insufficient free cash flow to consider paying dividends in the early stages of growth, and therefore the investor will seek their return by aiming to sell their shares when the business is disposed of.
In these circumstances, the cost of equity can be simplified by using the compound annual growth rate (CAGR) formula, which can be stated as follows:
i = (FV / PV)(1 / n) - 1
PV = Present value = Equity investment
FV = Future value = Value of investment at disposal
i = CAGR = Cost of equity
n = Number of years to disposal
Cost of Equity Formula Example
Suppose a business is seeking external investors to raise 70,000 in return for 40% of its equity. It’s financial projections show that at the end of 5 years, the business has grown and is estimated to be worth 650,000.
The cost of equity is calculated as follows:
PV = Equity investment = 70,000 FV = Value of investment = 40% x 650,000 = 260,000 n = Number of year = 5 Cost of equity = (FV / PV)(1 / n) - 1 Cost of equity = (260,000 / 70,000)(1 / 5) - 1 = 30%
In this example, the business seeks to raise 70,000 of new equity in return for giving away 40% of the ownership, which in 5 years should be worth 260,000.
Using the compound growth formula, 260,000 returned in 5 years time from an investment of 70,000, is equivalent to a 30% annual cost of equity.
Equity Cost Depends on the Valuation
Of course this calculation depends on the business achieving its financial projections. If at the end of 5 years the business was actually worth say 940,000, then the cost of equity would be as follows:
PV = Equity investment = 70,000 FV = Value of investment = 40% x 940,000 = 376,000 n = Number of year = 5 Cost of equity = (FV / PV)(1 / n) - 1 Cost of equity = (376,000 / 70,000)(1 / 5) - 1 = 40%
Likewise, if the business fails to meet its financial projections and collapses into bankruptcy, then the value of the investment on disposal and therefore the cost of equity will be zero.
In summary, the cost of equity cannot be predetermined in the same way that the cost of debt can be. The cost of equity ultimately depends on the percentage of ownership given up in return for the funding, the value of the business when the investment is disposed of, and the term over which the investment is made.
Outside equity is normally an expensive method with which the fund a business, but is often a necessity if injecting your own capital, using internal growth from retained earnings, or using debt financing are insufficient to fund the rapid growth.
Cost of Equity Finance and WACC
Equity financing is only one method of funding available to a business, the other being debt finance. Most businesses use both equity and debt, and the proportion of each used results in a weighted average cost of capital (WACC) for the business. The cost of equity financing is one component of the WACC calculation.