Cost of Equity

Cost of Equity is the return a company is expected to provide to its Equity investors to compensate them for the risk they undertake by Investing their Capital. It represents the Opportunity Cost of Investing in a particular company compared to other investments with similar risk profiles.

The cost of Equity can be estimated using various models, such as the Capital Asset Pricing Model (CAPM), which calculates it based on the risk-free rate, the Equity Beta (a measure of volatility compared to the market), and the expected market return.

Formula:

Cost of Equity = Risk-Free Rate + Beta × (Expected Market Return – Risk-Free Rate)

Example: If the risk-free rate is 3%, the expected market return is 8%, and the company’s Beta is 1.2, the cost of Equity would be calculated as follows:

Cost of Equity = 3% + 1.2 × (8% – 3%) = 3% + 1.2 × 5% = 3% + 6% = 9%

Case: Company A is planning to expand its operations and needs to attract investors. If the cost of Equity is determined to be 9%, this means investors expect at least a 9% return on their investment to justify the risk of Investing in Company A compared to other investment opportunities.