Companies issue equity securities on primary markets to raise capital and increase liquidity. This additional liquidity also provides the corporation an additional “currency” (its equity), which it can use to make acquisitions and provide stock option-based incentives to employees. The primary goal of raising capital is to finance the company’s revenue-generating activities in order to increase its net income and maximise the wealth of its shareholders. In most cases, the capital that is raised is used to finance the purchase of long-lived assets, capital expansion projects, research and development, the entry into new product or geographic regions, and the acquisition of other companies. Alternatively, a company may be forced to raise capital to ensure that it continues to operate as a going concern. In these cases, capital is raised to fulfill regulatory requirements, improve capital adequacy ratios, or to ensure that debt covenants are met.
Accounting Return on Equity
Return on equity (ROE) is the primary measure that equity investors use to deterine whether the management of a company is effectively and efficiently using the capital they have provided to generate profits.
It is computed as net income available to ordinary shareholders (i.e., after preferred dividends have been deducted) divided by the average total book value of equity (BVE). That is:
where NIt is the net income in year t and the average book value of equity is computed as the book values at the beginning and end of year t divided by 2.
Some formulas only use shareholders’ equity at the beginning of year t (that is, the end of year t – 1) in the denominator. This assumes that only the equity existing at the beginning of the year was used to generate the company’s net income during the year. That is:
Both formulas are appropriate to use as long as they are applied consistently.
The Cost of Equity and Investors’ Required Rates of Return
