Cost Of Equity
Cost of Equity Formula:
Cost of Equity = Risk-Free Rate of Return + Beta * Market Risk Premium
Components of the Cost of Equity:
- Risk-Free Rate of Return: The return on a risk-free investment, such as Treasury bonds or government securities.
- Beta: A measure of a company’s sensitivity to changes in the overall stock market.
- Market Risk Premium: The additional return that investors demand for taking on the risk of an investment compared to a risk-free investment.
Steps to Calculate Cost of Equity:
- Identify the risk-free rate of return.
- Measure the company’s beta.
- Determine the market risk premium.
- Use the formula above to calculate the cost of equity.
Additional Considerations:
- A company’s cost of equity is used to calculate its weighted average cost of capital (WACC).
- The cost of equity is a key component in financial modeling and valuation.
- The cost of equity can fluctuate over time based on market conditions.
- The cost of equity can vary between companies based on their size, industry, and financial strength.
Example:
Assuming a risk-free rate of return of 2%, a beta of 1.2, and a market risk premium of 4%, the cost of equity for a company would be:
Cost of Equity = 2% + 1.2 * 4% = 8%
Therefore, the cost of equity for this company is 8%.
Formula Variations:
- Capital Asset Pricing Model (CAPM): A variation of the cost of equity formula that uses the cost of debt as the risk-free rate of return.
- Jensen-Ross Model: A model that adjusts the cost of equity for the presence of corporate taxes and debt.
Conclusion:
Calculating the cost of equity is an important process in financial analysis. By considering the risk-free rate of return, beta, and market risk premium, investors can estimate the cost of equity for a company.
FAQs
What do you mean by cost of equity?
Cost of equity is the return that a company must offer to its shareholders to compensate them for the risk of investing in the company.
What is the cost of equity in WACC?
In the Weighted Average Cost of Capital (WACC), cost of equity represents the cost of financing through equity, which is combined with the cost of debt to calculate a companyโs overall cost of capital.
Why is it called cost of equity?
It is called the cost of equity because it reflects the cost incurred by a company to raise funds through equity, represented by the returns expected by shareholders.
What is the levered cost of equity?
Levered cost of equity accounts for a companyโs debt in its capital structure and reflects the increased risk and return required by equity investors due to leverage.
How is the cost of equity relevant in India?
In India, the cost of equity is calculated using local risk-free rates (e.g., government bond yields), market risk premiums, and the beta of the stock specific to the Indian market.
