Cost of Equity Capital - Coursework Example

Cost of Equity Capital Name Institution Date Cost of equity capital Cost of equity capital refers to the rate of return in which a company or an organization is required for investment purposes as a common stockholder (Kenneth, 2010). The formulae that is used to calculate the cost of equity capital is given by dividends per share (for the next year) divided by current market value of stock then added to dividend growth rate (Kenneth, 2010). A company’s cost of equity capital represents the compensation that the market demands in the exchange for owing the assets and bearing the risks of ownership (Kenneth, 2010). In order for a company to add value on the cost equity capital, then the company is supposed to earn a return on equity in excess. The cost of the equity can be tricky while calculating as the share capital carries no explicit cost unlike debt where the company is supposed to pay on in form of predetermined interest (Kenneth, 2010). Equity therefore do not have a concrete price that the company must have to pay but that doesn’t mean the will be no costs of equity in existence (Kenneth, 2010). The cost of equity capital is basically what it costs the company in maintaining a share price that will be satisfactorily to investors. Why equity capital costs are important in globalised firms in relation to CAPM Equity capital costs are important in globalised firms since a change in perceived risk significantly alters a firm’s fair value, even when the current free cash flow and growth rate remain unchanged (Gerhard, 2007). This role applies to only firms with separate subsidies operating in other countries since each firm will be required to promote its own fair value that will be changed by the perceived risks (Stulz, 1995). For example, a two percent rise in the globalised firms equity capital cost from 8% to 10% will equal a two percentage point in the rise of risks. The two percent rise of risk will translate to a staggering decline in the fair value. If the firm’s risks continue to rise further the expected fair value will fall too (Gerhard, 2007). According to capital asset pricing model under asset pricing, if the estimated price of the asset is higher than that of the CAPM valuation then the asset is undervalued which will suggest miss-pricing of the asset in security market line (Gerhard, 2007). Therefore this shows how the firm’s equity capital cost is important since when the cost of capital raises, its share price must fall until it reaches a new lower fair value (Gerhard, 2007). Equity capital cost is important in globalised firms since it acts as a measure and best indicator of the future stock prices (Christine, 1997). This major important role is applied to all firms with all forms of global operations. This is because globalised firms with all forms of globalized operations will be able to use approximation method of the equity capital cost to predict the future stocks that they can invest in (Christine, 1997). According to the capital asset pricing model (CAPM) it indicates that investors will be compensated through risk and time value of the money (Stulz, 1995).The metric that is mostly used in association with the future stock prices more than the consideration of the cash flow, firms tend to use proper estimates of the cost of equity capital. A fair approximation of the equity cost of capital will improve investment results (Christine, 1997). The use of equity capital cost has brought about the management of working capital in the firms (Basak, 1996). This role is applicable to both firms with separate subsidiaries operating in other countries as well as firms with all forms of global operations. The management of working capital uses a combination of techniques and policies that will manage the working capital (Basak, 1996). These policies are aimed at managing the current assets which includes inventories, debtors and cash equivalents so that returns and cash flows will be acceptable. In recognition of this working capital management policies there will be an observation of the CAPM methods in the globalised firms as a major concept of the equity cost of capital (Basak, 1996). Capital cost of equity is a risk measure of securities firms are to venture upon in other countries (Basak, 1996). This important role of equity capital cost implies to globalized firms’ with separate subsidiaries operating in other countries to improve on the return of security or a portfolio that equals the rate on a risk free security plus a risk premium (Basak, 1996). By the use of the capital asset pricing method if the expected return does not meet the required return then the investment should not be undertaken as the risk measure in security is high (Basak, 1996). Evaluation of the firm’s projects is met as a goal in the observation of the equity cost of capital (Christine, 1997). This role is applicable to both firms with separate subsidiaries operating in other countries as well as firms with all forms of global operations. According to CAPM it is the minimum return that investors expect to provide a capital to the company hence setting up a benchmark that a new project has to be started (Christine, 1997). Therefore equity capital costs assists globalized firms to evaluate a number of projects that are suppose to implement to supplement their cost of capital (Christine, 1997). Globalization led to lower cost of equity capital for firms According to Stulz, (1999) it is true that globalization has led to lower cost of equity capital for firms since globalization has brought up reductions in opportunities for the insider trading. Globalization is reducing these costs to many firms and the cost reductions have both increased the firm’s value directly and indirectly (Amihud, 1986). The reasoning behind this is to ensure investors will pay more to transact a security which will enhance stabilized securities. Globalization has helped to heighten the world economy through stabilized securities as investors will pay more for securities thus lowering the cost of equity capital for the firms (Amihud, 1986). The rate of globalization has created more wealthy equality throughout the world as a result of the lower cost of equity capital in firms (Stulz, 1999). According to Amihud, a lot of people have contended that their standards of living have gone down as a result of globalization, and the flip side to this is that a thousands of people have jobs, can provide for their families and they have started their own businesses thus creation of more wealthy equitable in the world. This is a result of the globalization processes firms are undergoing which has led to lowering of cost of equity (1986). Globalization has also brought forward increased competition in the market making and the investment services (Stulz, 1999). Many firms that have entered the global capital market have access to investments banks that they can compete for their businesses and hence lowering their market prices (Jomo, 2007). These firms can also choose to reduce the cost of transacting so as to cope up effectively with the other firms in the market in offering services as a concept of increased rate of globalization that has led to lowering of cost of equity in many firms (Haiwen, 2010). This will ensure that the firm wins the competition in the market. With the reduction of transaction costs there has been greater liquidity that has been a product of the globalization through an indirect impact on the monitoring of management (Jomo, 2007). With greater liquidity the markets for a firm’s equity becomes more efficient in the sense that it is more quickly and accurate to reflects about the firm cost of equity capital (Jomo, 2007). Globalization has lowered the firms cost of equity which has facilitated all the monitoring of management activities to ensure there is greater liquidity being met in the firm as a result of the globalization process (Jomo, 2007). Greater liquidity makes it easier for active investors in a firm to accumulate positions in stock and sell these positions as well. Globalization has also led to more efficient markets due to lowering of costs of equity in the firms (Lilach, 2011). In order to evaluate the impact of globalization on the cost of capital, there have been indirect approaches that have ensured the markets are liberal and satisfactorily in increasing the empirical impact that has rendered lower costs in equity (Lilach, 2011). Therefore as a result of globalization in lowering the cost of equity in firms there has been an introduction of liberal markets that are efficient (Lilach, 2011). Lowering of cost of equity among the firms due to globalization has contributed to foreign trade in an economy (Jomo, 2007). Comparative advantage has always been a factor where in the earlier times they had to resort to unfair means and destruction was highly practiced (Jomo, 2007). In today’s globalised world business activities are carried out in a proper manner. Therefore the introduction of the globalization in firm has ensured foreign trade is carried on effectively without any setbacks that will influence the economy negatively (Jomo, 2007). Spread of technical know-how is another positive impact that firms have come across due to globalization which is lowering the rate of cost of equity in the firms (Rene, 1999). It is true that a decline in the cost of equity in firms promotes the existence of the technical know-how being spread across in the world (Rene, 1999). Developing countries are also on the forefront to embrace globalization in their firms as it spreads ideas that are accompanied with technical skills (Rene, 1999). Therefore the use of globalization strategies will lower cost of equity in firms which in turn will make it effectively to spread technical know-how in the firms (Rene, 1999). Globalization has lowered the cost of equity in firms which in the other phase is an additional factor in spreading education (Lilach, 2011). Education is one of the most powerful effects of globalization in the world today. One can acquire knowledge and spread it to the other countries that are developing. As a result of lower cost of equity in the firms due to globalization, the spreading of education will continue to be in existence whereby employees and other members associated with the firm will continue to share knowledge hence spreading education (Lilach, 2011). Advantages of firms operating globally for their cost of equity if they are listed on US stock exchanges Firms operating globally have the ability to raise further capital when they are listed on the US stock exchange (Ravi, 2011). An initial listing usually increases the firm’s ability to raise further capital through various processes such as rights issue, qualified institutional placements and preferential issue which will attract more professional investors (Ravi, 2011). The capital raised through the enlisting of the firm in the stock exchange will boost the cost of equity of the firm (Ravi, 2011). The firm will also enjoy fair prices for the securities being offered as they have been listed in the United State stock exchange (Nicolla, 2005). As seen in the capital asset pricing model, securities on the expected return if it does not meet the required return then the investment will need to be aborted (Nicolla, 2005). Therefore securities of a globalised firm has an effect on the cost of equity since it determines the number of investors and also if the investment process will be viable. Globalised firms will therefore enjoy fair prices for their securities when they are listed on the US stock exchange which will have a positive effect on the cost of capital by increasing it (Christopher, 2008). Another advantage globalised firms are entitled to while they are listed on the United States stock exchange is that there is a benefit to the public (Andy, 2013). The data that is daily culled out by the stock exchange in the form of price quotation will provide valuable information to the public which can be used to determine viable projects and research studies for the firm (Andy, 2013). In this by being aware to the public, the globalized firms will improve the cost of equity through the investments it can achieve by the publicity being advertised on US stock exchange market (Andy, 2013). Globalised firms will enjoy supervision and control of trading of securities in the market by being listed in the United States stock exchange (Campollo, 1997). The transactions in the listed securities are entitled to uniformly being carried out as per the regulations and bylaws of the US stock exchange (Campollo, 1997). All these transactions are carried out in a regulated and preventive method that will improve the confidence of investors while protecting them too. Through the supervision and control of the trading activities the firm will enjoy efficient transaction in the cost of equity when they are listed in the US stock exchange (Campollo, 1997). References Amihud, Y., and Haim, M. (1986). Asset pricing and the bid-ask spread, journal of financial economics, 17, 223-249. Andy, Rao. (2013). 4 positive impacts of globalization world economy, retrieved from http//www.kstatecollegian.com/2013/05/07/4-positive-impacts-of-globalization-on-world-economy/ Basak, S. (1996). An inter-temporary model of international capital market segmentation, journal of financial and quantitative analysis, 31, 161-188. Campollo, P. (1997). Equity investment in emerging markets, NYSE conference on the globalization of financial markets, Cancun, Mexico. Christine, B. A. (1997). Disclosure level and the cost of equity capital, the accounting review, 72, 323-249. Christopher, J. B, (2008). Road pricing, the economy and the environment, Berlin: Springer publishers. Gerhard, K., and Nick, B. (2007). The impact of voluntary disclosure on cost of equity estimates in a temporary setting, journal of intellectual capital, 8(4), 577-594. Haiwen, Z. (2010). Globalization and the size distribution of firms, journal of economic record, 8(6), 84-94. Jomo, K.S. and Jacques, B. (2007). Flat world, big gaps: economic liberation, globalization, poverty and inequality, Penang, Malaysia: Orient Longman. Kenneth, H. (2010). Cost of equity capital: the best indicator of future stock prices, retrieved from http//www.seekingalpha.com/article/219904-cost-of-equity-capital-the-bets-indicator-of-future-stock-prices/ Lilach, N. (2011). What constitutes the costs and advantages of firms investing overseas, managerial and decision economics, 32(8), 545-555. Nicolla, A. (2005). Economic policy in the age of globalization, New York, N.Y: Cambridge university press. Ravi, R. and Niron, H. (2011). The future of foreign direct investment and the multinational enterprise, Bingley, U.K: Emerald publishers. Rene, S. (1999). Globalization of equity markets and the cost of capital, NBER working paper, 1-70. Stulz, R. (1999). Globalization, corporate finance and the cost capital, Rene M RM Stulz, journal of applied finance, 12(3), 8-25. Stulz, R. M. (1995). Globalization of capital markets and the cost of capital: The case of nestle, journal of applied corporate finance, 1(1), 11-22. Read More