A business has, generally, two types of financiers: third parties - i.e., most often, the bank - and the partners themselves.
We know that a loan has a cost: third-party lenders, in fact, are remunerated with interest on the principal loaned, which therefore constitutes the cost of debt.
If shareholders are expected to be remunerated, there is no cost of equity (which is a cost for the company and a remuneration for the shareholders) that is established with an accuracy always equal to that of the cost of debt.
If shareholder's remuneration per se can be associated, at least in the short to medium term, with the compensation paid out (or profits distributed/dividends received), the cost of equity can take on different meanings depending on the size of the business, company policies,
context and risk.
In corporate finance theory we find the cost of equity, for example, in the concept of the weighted average cost of capital, in which the cost of debt and the cost of equity are precisely weighted so that investment decisions can be made to get a yield which is more than what is given as remuneration to all lenders-financiers.
Again in theory, this cost of equity corresponds to the minimum rate of return that a company must give to shareholders, taking into account certain elements such as:
- the rate of return on a risk-free asset (e.g., government bonds);
- the expected return on a portfolio consisting of comparable risky securities in the market;
- the risk arising from the volatility of the company’s return relative to the market return.
In reality, since there are many small businesses rather than listed companies, the calculation of this cost is still complex.
It is necessary to start from the analysis of the components of equity and assess their risk: equity is the sum of share capital, retained earnings and various reserves.
We can start by ’’stripping’’ equity of those components that are purely accounting (e.g., revaluation reserves) or by considering them at a value that reflects reality.
After this, there should be applied a connection of the value of equity to those assets (whether non-current, such as a building, or current, such as goods) that are financed with equity: we can assess how much they are expected to yield and the risk taken in keeping them fixed.
We can also think of the cost of equity being higher than the cost of debt: a basic rule of finance is that the higher the risk, the higher the return.
The entrepreneur’s money is certainly riskier than money lent by the bank, so it should cost more.
This can help with an assessment of the cost of equity capital that, in common business realities, takes into account the risk of the specific corporate structure.
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