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Basic definitions

Equity

The definition of equity from accounting standards (Chapter 5) is specific if not exactly helpful:

Equity is the residual interest in the assets of the entity after deducting all its liabilities. It may be sub-classified in the statement of financial position. For example, in a corporate entity, sub-classifications may include funds contributed by shareholders, retained earnings and gains or losses recognized in other comprehensive income.

Ordinary share capital - UK Companies Act 2006

560 Meaning of 'equity securities' and related expressions

(1) In this Chapter—

'equity securities' means:

(a) ordinary shares in the company, or

(b) rights to subscribe for, or to convert securities into, ordinary shares in the company;

'ordinary shares' means shares other than shares that, as respects dividends and capital, carry a right to participate only up to a specified amount in a distribution.

(UK Companies Act 2006)

The definition from IFRS - Financial Instruments Presentation - IAS 32 is similar to that of the framework:

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

Maybe the best way to define equity is to use the term 'risk capital' - shareholders are entitled to the excess of assets over liabilities, but could lose the lot!

Sources of funds

Funding for ventures can come from equity (risk capital), that is, from ordinary shares (UK), common stock (US) or from borrowing, which can take many forms.

Borrowing comes from a number of sources: straight debt, convertible debt, government grants and so on. Different security types, which represent different sources of finance, are expected to require or demand different returns.

Cost of capital

Cost of capital (rate): in its simplest form this is the weighted average cost of capital (funding) of a business. The average, weighted rate requires a knowledge of the cost of borrowing and the cost of equity or shareholders' funds. The cost of borrowing or loans will normally be quite clear - defined loan interest rates. The cost of equity may be more difficult to determine, but often markets will give an indication of what is expected.

TABLE 12.1 WACC with different % gearing

WACC with different % gearing

Table 12.1 shows the calculation at three levels or mixes of borrowing:

A All equity which demands a return of 14 per cent - the average then is 14 per cent as there is nil borrowing.

B 10 per cent borrowing: at a required rate of 8 per cent the average WACC is 13.4 per cent.

C 90 per cent borrowing: at 8 per cent the WACC falls to 8.6 per cent.

The arithmetical conclusion is that the more you can borrow at a cheaper rate, the lower your cost of capital. This will allow you either to invest in lower-return projects or to gear up the return to shareholders, as long as the operational business returns a rate higher than the WACC. This is demonstrated in the example below.

There are further examples of the calculation of WACC and the effect of gearing on investment strategy in Chapter 11.

 
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