There is a broad difference between external equity or new issue of shares and internal equity which is retained earnings. The cost of equity is applicable to both external as well as internal equity. Both have many other similarities too, however in this article, we will highlight the major differences between the cost of external equity and the cost of internal equity.
Some economists and finance professionals believe that equity capital is cost-free. The reason for this belief is that it is not legally binding for companies to pay dividends to ordinary shareholders. Also, the equity dividend rate is not pre-fixed like the interest rate or preference dividend rate.
However, it is not correct to assume that equity capital is totally free of cost.
Equity capital often carries an opportunity cost; and the ordinary shareholders provide investments in the expectation of dividends (along with capital gains) in proportion with their risk of investment.
The market price of the shares that are determined by the demand and supply forces in a well-functioning capital market reflects the required rate return of ordinary shareholders.
The shareholder’s required rate of return, which is equal to the present value of the expected dividends along with the market value of the share presents the cost of equity capital.
The cost of external equity could, however, be different from the shareholder’s required rate of return if the issued price is different from the market price of the share.
Generally, the shareholder’s required rate of return remains the same, whether the company is going for new shares or forgoing dividends. However, from a firm’s point of view, there is a difference between retained earnings which is the capital kept for new projects from the profit that is not distributed among shareholders, and the issue of equity shares.
The firm may have to issue a new share at a lower price than the market value. Issuing equity involves floatation costs. Therefore, raising funds externally is costlier in comparison to raising funds internally.
It is also notable that the issuance of new shares could be different from keeping a portion of the profit for future investments of new projects of the firm.
Although there is a cost associated with both the cases, issuance of new shares is pricier than foregoing the dividends. That is why, most of the firms choose internal fund-raising instead of going external.