Equity Capital Meaning Examples Cost Calculation

Equity Capital Meaning

It is one of the primary sources through which businesses obtain capital to finance their operations and overall development. The most common ways to raise equity funds are through a public and private issue of shares, and accordingly, it is also classified into private and public equity capital.

How to Calculate Equity Capital Cost?

The equity capital calculation method can vary based on the entity’s financial context. However, the general practice is to look at the company’s balance sheetCompany’s Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more or statement of profit and loss accountStatement Of Profit And Loss AccountThe profit and loss statement is a financial report that summarizes the company’s revenues and expenses over a period of time to determine profit or loss for that period.read more to pick the value of total assets and total liabilities.

Key Takeaways

Equity capital definition portrays it as the amount of money collected from owners and other investors in exchange for a portion of ownership right in the company.It is exceptionally beneficial for companies since it raises large sums of money that they can use for long-term projects.A good equity portfolio increases credit rating.The company does not need to repay the fund collected through equity financing. However, they are also associated with disadvantages such as being expensive for firms to raise and a complex dividend distribution process.

Total Equity = Total Assets – Total liabilities

The balance sheet portrays the value of total assetsTotal AssetsTotal Assets is the sum of a company’s current and noncurrent assets. Total assets also equals to the sum of total liabilities and total shareholder funds. Total Assets = Liabilities + Shareholder Equityread more as the sum of total liabilities and equities. Hence, total equity is the difference between total assets and liabilities.

You are free to use this image on you website, templates, etc., Please provide us with an attribution linkHow to Provide Attribution?Article Link to be HyperlinkedFor eg:Source: Equity Capital (wallstreetmojo.com)

Furthermore, the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM) can calculate the equity capital cost, indicating the rate of return that will flow to the shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more. In other words, it is the cost of distribution to shareholders. The calculation considers several factors, including the status of the market and the company’s overall risk. It uses historical information to come up with the pricing. The formula used to calculate the cost of equityCost Of EquityCost of equity is the percentage of returns payable by the company to its equity shareholders on their holdings. It is a parameter for the investors to decide whether an investment is rewarding or not; else, they may shift to other opportunities with higher returns.read more in this model is:

E(Ri) = Rf + βi * [E(Rm) – Rf]

In this formula, E(Ri) represents the anticipated return on investment, Rf is the return when risk is 0, βi is the financial Beta of the assetBeta Of The AssetBeta is a financial metric that determines how sensitive a stock’s price is to changes in the market price (index). It’s used to analyze the systematic risks associated with a specific investment. In statistics, beta is the slope of a line that can be calculated by regressing stock returns against market returns.read more, and E(Rm) is the expected returns on the investment based on market analyses.

Example

In various instances, the company may require selling a portion of itself to gain equity funds, and it creates a way for investors to own the company’s share. The equity finance can be obtained through self-funding by owners, offering partnership to friends and family, private investors, stock market issuance, venture capitalistsVenture CapitalistsVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more, etc. In simple terms, we can analyze that if the entity is a sole proprietorship, the equity section is referred to as owner’s equityOwner’s EquityOwner’s Equity is the amount of money belonging to the business owners after deducting all the liabilities. The examples include Retained Earnings, Accumulated Profits, Common Stock & Preferred Stock, General Reserves & other Reserves etc. read more. In contrast, it is indicated as stockholders’ equity for a corporation.

The equity section of the balance sheet discloses quantitative values of components like common stockCommon StockCommon stocks are the number of shares of a company and are found in the balance sheet. It is calculated by subtracting retained earnings from total equity.read more, preferred stockPreferred StockA preferred share is a share that enjoys priority in receiving dividends compared to common stock. The dividend rate can be fixed or floating depending upon the terms of the issue. Also, preferred stockholders generally do not enjoy voting rights. However, their claims are discharged before the shares of common stockholders at the time of liquidation.read more, additional paid-in capitalAdditional Paid-in CapitalAdditional paid-in capital or capital surplus is the company’s excess amount received over and above the par value of shares from the investors during an IPO. It is the profit a company gets when it issues the stock for the first time in the open market.read more, retained earningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more, other comprehensive incomeOther Comprehensive IncomeOther comprehensive income refers to income, expenses, revenue, or loss not being realized while preparing the company’s financial statements during an accounting period. Thus, it is excluded and shown after the net income.read more (OCI), and treasury stock. For instance, look into the balance sheet of Apple Inc., the shareholder’s equity section lists information about shares authorized, issued, outstanding, additional paid-in capital, retained earnings, and OCI. As of March 2021, Apple’s stockholder equity was $69.178 billion and around 16.97 billion shares outstanding.

Advantages and Disadvantages

As with any investment, several advantages and disadvantages are associated with equity fund.

The advantages are:

The stocks like common stocks and preferred stocks have no maturity date. Consequently, the company does not have the right to demand back the equity shares strictly. A shareholder would therefore be more secured when holding equity shares.It increases the creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more of a company. If it gains many equity shareholders, then they act as a form of collateral for the company. It gives the company more leverage to get more funds and negotiate better terms with lenders or other stakeholders.It is not obligated always to pay dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more to equity shareholders for the company. So, it will be helpful when the company faces a cash crunch. It can then use the money intended for dividend distribution to pay for other events without worrying about legal liabilities.For investors, equity shares are preferable in most cases since they command a higher return on investment compared to other types of securities. However, it of course, depends on the performance of the company.

It has several disadvantages as well, including:

The company’s ownership becomes more and more diluted as it gains more equity shareholders. In some cases, this can make decision-making a slow process since it involves many shareholders. It can make the company miss out on opportunities that are tightly time-barred. To a company, the cost of giving out equity shares is high. Equity shareholders usually require a high return on investmentReturn On InvestmentThe return on investment formula measures the gain or loss made on an investment relative to the amount invested. The net income divided by the original capital cost of investment. Return on Investment Formula = (Net Profit / Cost of Investment) * 100
read more, particularly in the long run.Managing equity capital, in this case, costs more for the company. For instance, when paying out dividends, the money has to come out of profit after taxProfit After TaxProfit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more has been paid. In the case of other types of financing, the company would pay in interest, which would be tax-deductible, and therefore cost less for the company.Raising an equity fund is much more expensive than raising cash using other methods for a company.