Cost Of Equity

Cost Of Equity

Cost Of Equity | What Is Cost Of Equity

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 who 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.

Cost Of Equity
Cost Of Equity

Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest and equity investors seek dividends and/or appreciation in the value of their investment (capital gain). From a firm’s perspective, they must pay for the capital it obtains from others, which is called its cost of capital. Such costs are separated into a firm’s cost of debt and cost of equity and attributed to these two kinds of capital sources.

While a firm’s present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various models for estimating a particular firm’s cost of equity such as the capital asset pricing model, or CAPM. Another method is derived from the Gordon Model, which is a discounted cash flow model based on dividend returns and eventual capital return from the sale of the investment. Another simple method is the Bond Yield Plus Risk Premium (BYPRP), where a subjective risk premium is added to the firm’s long-term debt interest rate. In addition, the cost of equity can be calculated by (proposed by Gebhardt et.al. (2001) – see Further Reading Section) using the discounted residual income model to estimate the market implied cost-of-capital. The paper shows that a firm’s implied cost-of-capital is a function of its industry membership, B/M ratio, forecasted long-term growth rate, and the dispersion in analyst earnings forecasts. Moreover, a firm’s overall cost of capital, which consists of the two types of capital costs, can be estimated using the weighted average cost of capital model.

Cost Of Equity Formula

The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) or Dividend Capitalization Model (for companies that pay out dividends).

Cost Of Equity Formula
Cost Of Equity Formula

Cost Of Equity Calculator | How To Calculate Cost Of Equity

The cost of equity refers to two separate concepts depending on the party involved. If you are the investor, the cost of equity is the rate of return required on an investment in equity. If you are the company, the cost of equity determines the required rate of return on a particular project or investment.

Cost Of Equity Calculator
Cost Of Equity Calculator

There are two ways a company can raise capital: debt or equity. Debt is cheaper, but the company must pay it back. Equity does not need to be repaid, but it generally costs more than debt capital due to the tax advantages of interest payments. Since the cost of equity is higher than debt, it generally provides a higher rate of return.

KEY TAKEAWAYS

  • Cost of equity is the return a company requires for an investment or project, or the return an individual requires for an equity investment.
  • The formula used to calculate the cost of equity is either the dividend capitalization model or the capital asset pricing model.
  • The downfall of the dividend capitalization model, although it is simpler and easier to calculate, is that it requires the company pays a dividend.
  • The cost of capital, generally calculated using the weighted average cost of capital, includes both the cost of equity and cost of debt.

Cost Of Equity Capital

The Cost of Capital is the total cost of raising capital, taking into account both the cost of equity and the cost of debt. A stable, well-performing company, will generally have a lower cost of capital. To calculate the cost of capital, the cost of equity and cost of debt must be weighted and then added together. The cost of capital is generally calculated using the weighted average cost of capital.

Calculate Cost Of Equity | How To Find Cost Of Equity

CAPM takes into account the riskiness of an investment relative to the market. The model is less exact due to the estimates made in the calculation (because it uses historical information).

CAPM Formula:

E(Ri) = Rf + β* [E(Rm) – Rf]

Where:

E(Ri) = Expected return on asset i

Rf = Risk-free rate of return

βi = Beta of asset i

E(Rm) = Expected market return

Risk-Free Rate of Return

The return expected from a risk-free investment (if computing the expected return for a US company, the 10-year Treasury note could be used).

Beta

The measure of systematic risk (the volatility) of the asset relative to the market. Beta can be found online or calculated by using regression: dividing the covariance of the asset and market’s returns by the variance of the market.

βi < 1: Asset i is less volatile (relative to the market)

βi = 1: Asset i’s volatility is the same rate as the market

βi > 1: 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).

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%.

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