The cost of common equity financing is more difficult to estimate than the costs of debt and preferred equity
Explain why.
What will be an ideal response?
Common equity is unique in two respects. First, the cost of common equity is more difficult to estimate than the cost of
debt or cost of preferred stock because the common stockholders' required rate of return is not observable. For
example, they receive no stated coupon rate or set dividend payment. This results from the fact that common
stockholders are the residual owners of the firm, which means that their return is equal to what is left of the firm's
earnings after paying the firm's bondholders their contractually set interest and principal payments and the preferred
stockholders their promised dividends. Second, common equity can be obtained either from the retention and
reinvestment of firm earnings (internal equity financing) or through the sale of new shares. The costs associated with
each of these sources are different from one another because the firm does not incur any flotation costs when it retains
earnings, but it does incur costs when it sells new common shares.
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Indicate whether the statement is true or false