Cost of Equity, Leverage and P/E Intuitive Understanding
Grateful if any Money could shed light on these questions. I have googled and wallstreetoasised a lot but there's no answer from these perspectives.
When issuing equity, what does Cost of Equity mean to the COMPANY if it pays no dividends? I understand that Cost of Debt implies interest you have to pay, but what about Cost of Equity assuming you DO NOT pay dividends? It seems like the equity does not cost the company anything at all. Shareholders may gain from share price appreciation but how can the Company be impacted?
If a company issues debt, paying for interest will decrease levered FCF, and leverage will increase cost of equity, so implied Equity Value will be lower, and the share price will be lower given fixed share count. Then why would companies want to issue debt because it's "cheaper"?
Under scenarios of question 2, can I say change in P/E will be ambiguous b/c P and E both go down?
Many thanks.
Bump
Before answering the question, I have to tell you there are two ways to calculate COE: The dividend capitalization model and the capital asset pricing model. The first method requires a scenario that the company pays the dividend to its investors while the capital asset pricing model can be used in any conditions to get COE.m, which suggests that you can get COE even the company does not pay dividend.
For your further question about why to calculate COE if the company does not pay dividend, COE just means how much return you should secure if you as investor wants to invest in a company. It doesn't linked with dividend payment directly. As for why debt is cheaper, the company may want to retain control of the company while paying less with the benefit from tax deduction. Also, the future potential dividend payments and stock appreciation counts as part of the reasons. Sometime company even capitalizes the interests payment to decrease the tax payment by increasing D&A. Hope this will help.
Thanks for the reply!
So, say the Cost of Equity is 8% and Cost of Debt is 5%, the market cap is $100 and debt is $100.
From shareholder's perspective, surely shareholders expect to earn 8% or $8 from their investment; and debt holders expect to earn 5% or $5.
From the company's perspective, it pays $5 on debt to debt holders; but where does the $8 come from, if the company does not pay dividends?
I imagine the market cap will have to rise to $108 in this case, but it does not cost the company anything. So why is Cost of Equity called Cost? The only costs I can think of now are diluted earnings (which is theoretically available to shareholders) and potential dividends in the future. As long as I don't pay any dividends any let earnings sit on my balance sheet, why should I care if there's any cost associated with issuing stock? (like I'm a sht CEO and let the share prices go to hll, as long as I don't hold any shares)
I might have got lost in discussion, but I wish to learn about the cost to the company, rather than the share investors.
Again, just theoretical discussion, I believe in reality there's another situation.
Diluted earnings are indeed the cost. Any time you issue stock, you are diluting all future earnings.
It's called a cost because shareholders demand a certain return (8% in our case) on their investment. That is the cost to obtain capital from them. It dictates the percentage of future earnings that you will have to give away for a fixed set of cash flows (a higher cost of equity implies that they will require a greater percentage of your company for the same set of cash flows).
That cost will change depending upon market needs and expectations. If you don't pay out any dividends, and just choose to retain earnings, the market will make a decision about your future earnings potential (are you hoarding cash just to hoard it? to fund future acquisitions?). If the market decides that you are just hoarding cash or are making wasteful acquisitions, do you think that will make it easier or harder to raise equity capital? All else being equal, if it's harder to raise equity capital, do you think the cost of equity would remain at 8%?
For the 2 question you are forgetting that FFCE includes net borrowing and it means that it will also increase by the amount of the cash raised from the debt. Also cost of equity may not necessarily rise (it depends on the level of debt). For example if company didn't have much debt before and decided to issue a relatively small amount, then the probability of default may be insignificant anyway. Thus not causing cost of equity to rise.
Yep I forgot the net borrowings, sorry. The FCFE then will likely to increase given the interest is not insane. Then the net impact of cash flow and CoE is ambiguous if we're not sure how the CoE will change?
I believe FCFE will also increase in the future periods assuming the company will invest this cash in positive NPV projects. yeah, I believe the impact is ambiguous because cost of equity may also rise significantly
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