What Is Cost Of Equity?

Cost of equity is the return required by a company’s shareholders. Cost of equity is the hypothetical return investors must receive in order to justify the risk of owning an asset. Cost of equity is calculated using either the dividend capitalization model or the capital asset pricing model (CAPM).

How To Calculate Cost Of Equity

As stated previously, there are two methods used to calculate cost of equity. Shown below is the formula for each method.

Capital Asset Pricing Model:

Cost Of Equity = Risk Free Rate + (Beta X Market Risk Premium)

Dividend Capitalization Model:

Cost Of Equity = (DPS / Market Price) + Dividend Growth Rate

Where

DPS = Dividend Per Share

Cost Of Equity For Investors VS Companies

Cost Of Equity can mean different things depending on who is using it. As stated before, for investors, cost of equity represents a required return in order to justify the risk of investing in an equity. However, cost of equity is used by companies who are trying to gauge the required return on a new venture.

Why Use The Capital Asset Pricing Model?

The cost equity must take risk into account. Fortunately, the CAPM accounts for this factor in its formula. CAPM uses beta, which is a measure of a companies volatility against an index, as a measure of risk. While using beta as a measure of risk is controversial, CAPM implies that the higher the beta, the greater the risk. The market risk premium represents the premium investors can expect for taking on the risk of investing in the equity market. By linking market risk premium with an individual equity’s beta, investors can tailor this risk to reward assessment to a specific company. CAPM may be useful because not all companies pay shareholders a dividend, rendering the dividend capitalization model useless.

Cost Of Equity: Company Financing

Companies can receive financing via debt or equity issuance. However, the cost of equity is greater than the cost of debt. This is due in part to the fact that the interest expense that comes with debt can be used as a tax shield. Also, because equity investors have the last claim in the event of liquidation, they demand greater returns which is reflected in cost of equity. Combining cost of equity and cost of debt, and weighting them accordingly, is how investors can calculate weighted average cost of capital (WACC).