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Common equity is an accounting figure that relates to a company's total number of common shares of stock outstanding. Different factors can affect the cost of common equity associated with this figure. A few of these factors are dividends, current cost of common stock and the amount of cash needed to pay for specific projects. Other factors might affect the cost of common equity, depending on current market conditions. Companies must take all of these factors into consideration when attempting to use equity financing in their operations.
Dividends are small payments that a company makes to shareholders. These dividends per share represent a cost of common equity, because companies will not receive a return on this capital. Most companies will set a dividend policy that outlines the amount of dividends that a company will pay for each share of common stock. Companies might pay the dividends each quarter or on an annual basis. This policy allows a company to compute the costs of common equity for a certain period.
Another important factor is the cost of current common stock in the market. Companies will often need to know this figure when they desire to issue more shares of common stock. For example, a company might be opening a new division to produce goods or services. Financing this division through common stock may be possible. The current price for common stock shares typically will affect the total cost of the equity financing, along with the expected cost of capital for the shares.
The total cost of common equity that is needed to finance a division might also be a factor. For example, most companies desire a specific mix of debt and equity financing when paying for new business departments or divisions. The total cost of common equity for the business will increase after the company issues more shares to potential stockholders. The total common stock outstanding will increase on the company’s balance sheet. Increased equity financing represents a liability for a company, indicating that the company is more beholden to outside individuals.
A company can reduce its total liability and cost of common equity by repurchasing shares of common stock. This removes any liability to shareholders and lowers dividend payments. Though this requires cash up front to repurchase the shares, it will lower the company’s overall mix of external financing. The company must make a treasury stock purchase and buy back a specific amount of shares. For example, a reverse stock split of 1-for-2 will reduce outstanding stock.
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