The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm’s cost of equity represents the compensation the market demands in exchange for owning the asset and bearing the risk of ownership. The traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).
In finance, the cost of equity is the return (often expressed as a rate of return) a firm theoretically pays to its equity investors, i.e., shareholders, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations that are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
: Asset i is more volatile (relative to the market)
Expected Market Return
This value is typically the average return of the market (which the underlying security is a part of) over a specified period of time (five to ten years is an appropriate range).
Read Also: What Are Retained Earnings?
Example of CAPM
Chris is looking to invest in XYZ Co. (a US company) and would like to figure out his expected return on the security. The yield of a 10-year Treasury note is 2.21%, the beta of XYZ Co. is 1.34 and the average return of the S&P 500 over the past 10 years is 7%. What is the expected return per share?
- Rf = 2.21%
- βi = 1.34
- E(Rm) = 7%
E(Ri) = 2.21% + 1.34*(7% – 2.21%)
E(Ri) = 8.6286%
Chris’s expected return on a share of XYZ Co. is 8.6286%.