Rate of Return for Stocks and Bonds
Minimizing the corporate cost of capital is one of the companies' strategic aims, which has however to be considered jointly with corporate risk assessment (Emery et al., 2004). The issuance of equity, which requires the company to share its profits with investors in the form of dividends, as well shares the profit risks in exchange for higher equity capital cost compared to debt, which creates the trade-off between corporate cost of
capital and risk levels. This trade-off usually causes companies to create a capital structure consisting of debt and equity shares.
An equity stock is valued by investors based on its dividend yield and return on capital gains, or on changes in the asset value. As seen in the first example, the total investor's return rate consists of the two separate rates. The company is able to influence stock valuation by choosing the amount of dividends paid annually depending on its profits. Besides, the investors' expectations about profitability and capital gains influence the current share price. Dividend discount model equates the current price with the discounted dividends under an assumed growth rate and capital costs, and can be used to choose the fair amount of dividends to be paid. At the same time, a growth-oriented company may decide to reinvest its profits and withhold dividends. In this case, the company's share price/earnings per share (P/E) ratio signals the fair share value to investors, and the stock return consists of capital gains yield rather than dividend yield. The company is able to withhold dividends in the case of the low P/E compared to the industry, which would increase the demand and current share price for the stock.
Preferred stock equity is one of the instruments for a company to reduce its capital costs by assuming obligations to pay a fixed dividend. The second example illustrates that the preferred stock dividend is
calculated as a percentage of par value, similarly to bonds. This equity holds higher risk compared to common stock due to the fixed value of the dividends, but has a lower cost of capital for this reason. Additionally, preferred stock, similarly to common stock, provides capital gains yield to
investors.
Companies have a number of methods to estimate their cost of capital in order to either make capital structure optimization decisions or …
