What Is the Cost of Equity?

The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the 澳洲幸运5官方开奖结果体彩网:required rate of return. The tradiꦇtional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model (CAPM).

How the Cost of Equity Works

The cost of equity refers to two separate concepts, depending on the party involved. If you are the investor, the c♔ost 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.

There are two ways that 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 𝓡of interest payment💖s. Since the cost of equity is higher than debt, it generally provides a higher rate of return.

Cost of Equity Formula

Using the dividend capiꩵtalization model, the cost of equity is:

$\begin{aligned}&\text{Cost of Equity}=\frac{\text{DPS}}{\text{CMV}}+\text{GRD}\\&\textbf{where:}\\&\text{DPS}=\text{Dividends per share, for next year}\\&\text{CMV}=\text{Current market value of stock}\\&\text{GRD}=\text{Growth rate of dividends}\end{aligned}$​Cost of Equity=CMVDPS​+GRDwhere:DPS=Dividends per share, for&nbᩚᩚᩚᩚᩚᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ⁤⁤⁤⁤ᩚ𒀱ᩚᩚᩚsp;next yearCMV=Current market value of stockGRD=Growth rate of dividends​

Special Considerations

The dividend capitalization model can be used to calculate the cost of equity, but it requires that a company pays dividends. The calculation is based on future dividends. The theory behind the equation is that the company’s obligation to pay dividends is the cost of paying shareholders and, therefore, the cost of equity. This is a ♊limited model in its interpretation of costs.

The capital asset pricing model, however, can be used on any stock, even if the company does not pay dividends. That said, the theory behind CAPM is more complicated. The theory suggests that the cost of equity is based on the stock’s 澳洲幸运5官方开奖结果体彩网:volatility and level of risk comp🍰ared to the general market.

CAPM Formula

The formula for tไhe capital asset pricing model is:

$\begin{aligned}&\text{CoE}=\text{RFRR}\\&\qquad\quad+\text{B}\times\text{(MRR}-\text{RFRR)}\\&\textbf{where:}\\&\text{CoE}=\text{Cost of Equity}\\&\text{RFRR}=\text{Risk-free rate of return}\\&\text{B}=\text{Beta}\\&\text{MRR}=\text{Market rate of return}\end{aligned}$​CoE=RFRR+B×(MRR−RFRR)where:CoE=Cost of EquityRFRR=Risk-free rate of returnB=BetaMRR=Market rate of return​

In this equation, the 澳洲幸运5官方开奖结果体彩网:risk-free rate is the rate of return paid on risk-free investments such as Treasuries. Beta is a measure of risk cღalculated as a regression on the company’s stock price. The higher the volatility, the higher the beta and relative risk compared to the general market.

The market rate of return is the 澳洲幸运5官方开奖结果体彩网:average market rate. In gener🐬al, a company with a high beta—that is, a company with a high degree of risk—will have a ♛higher cost of equity.

Cost of Equity vs. Cost of Capital

The cost of capital is the total cost o♊f raising capital, taking into account bot🌳h 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 the cost of debt must be weighted and then added together. The cost of capital is generally calculated using the 澳洲幸运5官方开奖结果体彩网:weighted average cost of capital.

When considering the weighted average cost of capital, companies may favor 澳洲幸运5官方开奖结果体彩网:the financi♋al option that is least expensive. For example, its cost of equity may be 8%, while its cost of debt may be 4%. Assuming a company has a balanced🔯 capital structure (50% 🧔of each), the company's total cost of capital is 6%.

As a company goes out to seek additional capital, it often compares which method is cheaper than its weighted average cost of capital. In this case, the company's average debt costs less, so the company may be opposed to issuing additional equity at a higher cost.

How Will I Use This in Real Life?

Using the cost of equity has beneficial applications for both investors and businesses. For investors, they can use the cost of equity to determine whether a stock or private investment into a company offers enough of a return when compared to the risk. If 𒁏the expected return is below the 🅰cost of equity, then the investment may not be a good opportunity.

Businesses can use the cost of equity to assess whether new funding projects or investments will generate enough return to justify an equity investment or whether other investment choices, such as debt financing, are better. This can also help in deciding which types of projects to pursue.

The Bottom Line

A company's cost of equity is an important consideration as companies determine the best way to raise capital. Calculated as the dividends issued per share divided by the current market price (plus a growth rate) or by using the CAPM, the cost of equity is the expense a company should assume it must return back to investors based on prevailing costs. The cost of equity is often compared to the cost of debt when making capital structure decisions.