Cost of Equity - Explained

What is the Cost of Equity?

What is the Cost of Equity?

Cost of Equity has two meanings:

• Company - A company's expected return on a prospective project or business opportunity.
• Investors - The cost of equity is the rate of return demanded by investors.

A company expects a return on projects undertaken or investments made. Investors demand a return on the funds invested in a company.

What is the Amount of Return?

The amount of return is a percentage of the amount invested. This percentage is based upon the market rate of return for similar investments and the additional risks unique to the specific company.

What is the Cost of Equity Formula?

The cost of equity is primarily calculated using either of two formulas:

• Dividend Capitalization Model
• Capital Asset Pricing Model

What is the Dividend Capitalization Model?

The dividend capitalization model is the traditional formula for calculating the cost of equity (COE). The formula is:

CoE = (Next Year's Dividends per Share/ Current Market Value of Stocks) + Growth Rate of Dividends

Example of the Dividend Capitalization Model

For example, ABC, inc will pay a dividend of \$5 next year. The current market value per share is \$25. The expected growth in dividends is 8% or (.08). CoE = .2 (or \$5 / \$25)+ .08 = .28 or 28% CoE = \$25 x .28 = \$7

This method calculates the cost of equity to the company when paying dividends to investors. The problem is that companies don't always pay dividends.

Capital Asset Pricing Model and the Cost of Equity

The Capital Asset Pricing Model (CAPM) is a commonly accepted formula for calculating the Cost of Equity.

The formula is: Re = rf + (rm rf) * , where

• Re (required rate of return on equity)
• rf (risk free rate)
• rm rf (market risk premium)
• (beta coefficient = unsystematic risk).

The Rf (risk-free rate) refers to the rate of return obtained from an investment that is totally free from credit risk (risk of default). Investments that have risk-free rates include government bonds and treasury bills.

(Beta) refers to the reaction of a share price against the market. A beta value of one indicates that a share's price moves with the general market. A beta value of less than one means that that share price is resilient to market changes. A beta of more than one indicates that the share price is very volatile in its movements as compared to the overall market.

(Rm Rf) refers to Equity Market Risk Premium (EMRP). This is the difference between the risk-free rate and the market rate.

What is the Weighted Average Cost of Equity?

The weighted average cost of equity is used to calculate the cost of equity if a company has multiple types of equity.

The Weighted Average Cost of Equity (WACE) attributes different weights to different equities. It is a more accurate calculation of the total cost of equity of a company.

To calculate WACE, the cost of new common stock (i.e 24%) must be calculated first, then the cost of preferred stock (10%) and retained earnings (20%).

To calculate further, the total equity occupied by each of the above forms will be calculated, let's say the have; 50%, 25%, and 25% respectively.

These figures are then multiplied by the cost of each form of equity to arrive at WACE.

Hence, WACE = (24%50%) (10%25%) (29%25%) = 19.5%