Determining the cost of common equity capital: The direct method

One of the most critical aspects of the corporate capital budgeting process is the determination of a proper “hurdle rate” or “cut-off” rate to employ in the screening of proposed uses of funds. This hurdle rate is now commonly referred to in both industry and the literature of financial management as the cost of capital. General agreement on how to measure the equity component of the cost of capital (i.e., the cost of common equity) has not yet been achieved by either practitioners or theorists. A unique approach that shows considerable promise differs from the abstract mathematical techniques typically used. It involves quizzing directly a sample of the corporation's existing common stockholders as to their dividend and capital gain expectations. Proper interpretation of the responses can provide top corporate management with an estimate of the cost of equity capital, as represented by the returns (expected) by shareholders. Thus, top level management has more complete information from the firm's owners on the returns that are expected from the investment of retained earnings.