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 look for a higher return than providers of debt finance due to the risk involved. 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. Consequently 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 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. Additionally they might also make gains when they sell their investment.
Most startup businesses have insufficient free cash flow to consider paying dividends in the early stages of growth. Consequently 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. The formula can be stated as follows:
When using this formula the variables have the following meanings.
FV = Future value = Value of investment at disposal
i = CAGR = Cost of equity
n = Number of years to disposal
Cost of Equity Formula Example
To illustrate suppose a business is seeking external investors to raise 70,000 in return for 40% of its equity. Additionally 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 is calculated as follows:
PV = Equity investment = 70,000 FV = Value of investment = 40% x 650,000 = 260,000 n = Number of years = 5 Cost of equity = (FV / PV)(1 / n) - 1 Cost of equity = (260,000 / 70,000)(1 / 5) - 1 = 30%
As can be seen the business seeks to raise 70,000 of new equity in return for 40% of the equity. Additionally the business should be worth 260,000 in 5 years time.
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.
Cost Depends on the Valuation
Of course this calculation depends on the business achieving its financial projections. To illustrate suppose at the end of 5 years the business was actually worth say 940,000. In this case 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 years = 5 Cost of equity = (FV / PV)(1 / n) - 1 Cost of equity = (376,000 / 70,000)(1 / 5) - 1 = 40%
The cost has increased as a result of the increase in the valuation of the business.
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 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 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.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.