Why do we include cost of equity in WACC ?

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wymiatacz997

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Hi, I have one question that is bothering me.
When a Company issues shares ie. USD 100 m.and gets money from IPO all this money goes to Shareholder’s Capital in the Balance Sheet.
And from now on the Company doesn’t have to pay anything to investors who bought its shares. So the cost of equity is not a real cost as opposed to cost of debt which is a real cost, meaning the Company has to pay interest and repay principal.
So why do we include cost of equity in WACC in DCF models?
 
That’s a great question. I had assumed it was because now the company has shareholders that expect return on their investment whether that be from dividends, stock buy backs, or increase in stock share value. It is a responsibility of return that must be met just like paying debt coupons and interest.
 
It’s an implicit cost rather than an explicit cost. They’re both real costs, however.
 
Thank you both for your answer.
As you said it KMeriwetherD:
“is a responsibility of return that must be met just like paying debt coupons and interest.”
I know investors expect return. But what happens when the Company doesn’t pay cash neither in form of dividends nor in the stock buyback and it’s share price drops ? What happens to Shareholder’s Equity on the Balance sheet when investors sell the stock ? - nothing.
Let’s assume investors behaved irrationaly and decided that the industry our firm operates in is out of fashion/boring/unethical. Our share price drops 90 % but the fundamental value of the Company did not change one bit.
My point is: Why our Company should even bother with it’s stock price on the secondary market? I know, management bonuses are dependend on the stock price, managers receive stock options and so on, but the stock price on the secondary market does not have any influence on the ability to generate cash flows.
Since our Company doesn’t pay dividends, doesn’t buy back shares, and investors decided the Company operates in boring industry so the stock price falled and then remained at the low level - the cost of equity is 0, isn’t it ?
 
Very interesting question. If Corporation XYZ issued stock once and for all the cost of capital would not be an issue.
However, corporations MAY need more capital later on so they have to offer adequate return.
 
“However, corporations MAY need more capital later on so they have to offer adequate return.”
So, assuming there is only one IPO and the Company plan no capital raising in the future (with all the assumptions in my previous post) that means cost of equity is 0 and we should discount it only with the cost of debt ?
 
If the only capital a company will raise is debt capital, then its WACC should be based only on debt capital. It’s not a matter of the cost of equity being zero; it’s a matter of the weight of equity being zero.
 
Yes. You are right.
However, three points should be considered:
1)No one is going to lend money on good terms to such a business
2)Most corporations reward higher management according to the level of the stock.
3)If the stock is low the company may become the target of a takeover that will oust current management.
 
So assume the Company is financed solely by equity. Then what is the cost of equity in the case I described ?
 
It’s sort of an abstraction. You are to imagine that the company is expected to make a certain return on its equity for being a public company, and if it does not do so, why invest? Imagine if the company was *required* to pay dividends on that equity, wouldn’t it have an explicit cost? Now let’s assume that the company instead of being required to pay dividends, reinvests it into the business, did the cost disappear? Of course not, it’s now reflected in investor expectations. Therefore the company’s equity has an existential cost.
It’s a good question.
 
S2000 and Palantir’s observations are spot on. I would also add the following thought exercise, which adds to cdealbequerque’s third point above which got lost. It deserves to be discussed, because it is very relevant to why companies must reward shareholders and thus have a cost of equity.
Common stock shares represent ownership in a company. Suppose a company issues an IPO and never rewards those investors. Once investors catch on to management’s lack of commitment to the shareholders, the stock price will sink, right? Then when it does, outsiders can buy up majority ownership for pennies on the dollar, come in, and fire all existing management and replace with their own people, sell the company’s assets, or any number of profit-seeking activities that would be deleterious to management’s current livelihood.
So you see, it is in management’s best interest to service their current equity obligation. Doing so creates an inherent cost of equity.
 
Because equity has a cost. Not meaning to be flippant. When you want to sell future cash flows, the amount you will receive is dependent on the certainty of the results. If the presumed probability is high, the cost is low. If the probability is low, your cost is high. The cost is real and relevant. The same is true if you are going to risk current capital for future capital. If a new project can’t overcome the cost of capital, something else should be done with the money. Stock repurchase, dividend, third party investment, debt buy back. I don’t believe the concept is an abstraction. It is an integral part of corporate finance. You would be flying blind without it.
 
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