The "cost of equity" is related to the shareholder’s return. In general, the Cost of Equity is the shareholder’s required rate of return that makes the market value of share equal to anticipated dividends. The cost of equity, in other words, is the expense of capital a company pays to its shareholders for the investment they have provided in the business.
Equity capital can be raised both internally and externally.
In case of internal cost of capital, the companies raise capital through retained earnings.
In case of external cost of equity, the companies earn the investment by issuing new shares. In both cases, shareholders are the providers of funds for the capital expenditure.
Generally, the shareholder’s required rate of return remains the same whether the company is going for new shares or forgoing dividends.
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. While issuing equity, involves floatation costs. Therefore, raising funds externally is costlier in comparison to raising funds internally.
Some economists and finance professionals argue that the equity capital is free of cost. The reason for this argument is that it is not binding legally for firms to pay dividends to ordinary shareholders. Moreover, the equity dividend rate is not fixed like the interest rate or preference dividend rate. It is, therefore, wrong to assume that equity capital is free of cost.
As is obvious, equity capital involves an opportunity cost; and the ordinary shareholders supply funds in the expectation of dividends (along with capital gains) commensurate with their risk of investment. The market price of the shares that are determined by the demand and supply forces in a fit and well-functioning capital market reflects the required rate return of ordinary shareholders.
Thus, 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.
It is therefore clear that there is a cost of equity. Or, in other words, equity is not cost-free. The determinant of the cost is the shareholder’s rate of return in the case of both internal and external equity. Therefore, saying that equity is cost-free is a fallacious argument.