Common Equity

Definition

Common equity represents the ownership interest in a company that is held by its common shareholders. It is the residual claim on a company's assets and earnings after all other claims, such as debt and preferred stock, have been satisfied. Common equity is a crucial component in calculating a company's weighted average cost of capital (WACC).

5 Must Know Facts For Your Next Test

1. Common equity represents the ownership interest of a company's common shareholders, who have a residual claim on the company's assets and earnings.
2. The cost of common equity is a critical component in calculating a company's WACC, as it reflects the return that common shareholders require for providing capital to the firm.
3. The cost of common equity is typically higher than the cost of debt, as common shareholders bear more risk and have a lower priority claim on the company's assets.
4. The market value of a company's common equity is determined by the market price of its common stock multiplied by the number of outstanding shares.
5. Retained earnings, which are the portion of a company's net income that is not distributed as dividends, are considered part of the company's common equity.

Review Questions

• Explain the role of common equity in the calculation of a company's weighted average cost of capital (WACC).
  • Common equity is a key component in the calculation of a company's WACC. The cost of common equity, which represents the return required by common shareholders, is weighted based on the proportion of the company's total capital structure that is financed by common equity. This weighted cost of common equity is then combined with the weighted costs of other capital sources, such as debt and preferred stock, to arrive at the overall WACC. The WACC is a critical metric used to evaluate a company's financing decisions and to assess the viability of potential investment projects.
• Describe the relationship between common equity and a company's shareholders' equity.
  • Common equity is a subset of a company's shareholders' equity. Shareholders' equity represents the net worth of the company and includes both common equity and preferred equity. Common equity specifically refers to the ownership interest held by the company's common shareholders, who have a residual claim on the company's assets and earnings after all other claims, such as debt and preferred stock, have been satisfied. The market value of a company's common equity is determined by the market price of its common stock multiplied by the number of outstanding shares, while the book value of common equity is calculated as the difference between the company's total assets and its total liabilities.
• Analyze the factors that influence the cost of common equity and explain how changes in these factors can impact a company's WACC.
  • The cost of common equity is influenced by several factors, including the risk-free rate, the market risk premium, and the company's beta. The risk-free rate represents the return investors can expect from a risk-free investment, such as government bonds. The market risk premium is the additional return that investors require for investing in the overall stock market, and a company's beta measures the volatility of its stock relative to the market. As these factors change, the cost of common equity will also change, which in turn will impact the company's WACC. For example, if the market risk premium increases, the cost of common equity will rise, leading to a higher WACC. This higher WACC may then affect the company's financing decisions and the viability of potential investment projects.

Related terms

Shareholders' Equity: Shareholders' equity is the value of the assets remaining after deducting the company's total liabilities. It represents the net worth of the company and includes common stock, additional paid-in capital, and retained earnings.

Preferred Stock: Preferred stock is a type of equity security that gives the holder a claim on the company's earnings and assets that is superior to the claims of common stockholders. Preferred stockholders typically receive dividends before common stockholders and have a higher priority in the event of liquidation.

Weighted Average Cost of Capital (WACC): Weighted Average Cost of Capital (WACC) is a calculation of a firm's cost of capital in which each category of capital (common equity, preferred equity, and debt) is proportionately weighted. WACC is the average rate a company expects to pay to finance its assets.