Hey guys,
This is a bit more of a conceptual question with something I have always struggled with. This may seem like a stupid question, but in regards to cost of capital, why does the cost of equity matter?
The company does not actually have to pay the required rate of return on equity (assuming no dividends). I understand that investors require that rate of return otherwise they would just go to a different investment with similar risk. But if they don’t receive their required rate of return, what actually happens? They sell their shares in the secondary market. right? The firm still has the money it raised and doesn’t incur any costs if this happens.
Say with a simple example if a company was raising $100. They used debt for 50% and equity for 50%. The interest on the debt was 5% and the required return based on CAPM is 10%. Assume no tax and the company doesn’t pay dividends. So WACC is 7.5%. They borrow the $50 and pay $2.50 for the year but do not pay any dividends or anything to equity holders.
If they company had a project that led to revenue of $5 and no other costs, they would make a profit of $2.50. The share price might go up or down and the equity investors may or may not get their 10% returns, but that doesn’t really affect the company right? But using IRR or NPV will say not to undertake the project.
I feel like there is something really obvious I am missing in my conceptual understanding of this. I don’t think it will matter for the exam but I just want to understand properly.