Cost of Equity can be defined as the company’s cost to raise finances from selling equity. In other words, the cost of equity can be defined as the rate of return that the company pays to equity investors.
The cost of Equity is mainly used to assess the overall attractiveness of investments. This includes both internal projects as well as external acquisition opportunities that the company has.
In this regard, it is also important to highlight the fact companies mostly use a mix of equity and debt financing.
However, amidst both the options, it can be seen that raising money through equity financing being relatively costlier.
Calculation of Cost of Equity
Cost of Equity can be calculated using CAPM (Capital Asset Pricing Model), as well as Dividend Capitalization Model.
Capital Asset Pricing Model (CAPM): Capital Asset Pricing Model (CAPM) is a method that incorporates the riskiness of investment that is relative to the market.
The model takes into account a number of estimates, because of which it cannot be regarded as perfectly exact or accurate. It is calculated, using the following formula:
E(Ri) = Rf + βi * [E(Rm) – Rf]
In this formula,
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return
In the above formula, Beta can be defined as the measure of systemic risk of the asset that is relative to the market. On the other hand, the expected market return is basically the typical and average return of the market over a specified period of time.
Dividend Capitalization Model: The dividend Capitalization Model can be used by companies that regularly pay dividends to their shareholders. Furthermore, it also assumes that dividends grow at a relatively constant rate.
This particular model does not account for underlying investment risk as compared to CAPM. The Dividend Capitalization Formula is the following:
Re = (D1 / P0) + g
Re = Cost of Equity
D1 = Dividends announced
P0 = currently prevalent share price
g = Dividend growth rate (historic, calculated using current year and last year’s dividend)
Cost of Equity can be seen as an increasingly important component used to analyze the underlying cost associated with managing and servicing equity for the cause of the company.
However, a couple of comparisons need to be drawn between other tools, which can contribute positively to the overall decision-making process.
Firstly, as far as the cost of equity compared to the cost of debt is concerned, it can be seen that cost of equity is higher than the cost of debt because of several reasons.
As a matter of fact, it can be seen that debt holders are paid before the equity investors. They are prioritized compared to equity holders in the sense that debtholders can get guaranteed payments, whereas equity investors are not.
Debt holders also get the security of the amount invested in the form of collateral that is offered. On the other hand, equity is a relatively riskier investment with no collaterals.
Therefore, under the risk and return principle, it makes sense to analyze that investing in equity is higher than the risk when it comes to investing via debt.
Hence, the cost of equity is higher (because of the higher risk involved) compared to the cost of debt (because of lesser inherent risk).
Usage of Cost of Equity in calculating WACC
Cost of Equity is a handy tool to calculate WACC (Weighted Average Cost of Capital). WACC is used to calculate the underlying cost of capital that the company has.
WACC amalgamates both costs of debt and equity to estimate the overall inherent cost of the business. Without correctly estimating the cost of equity, the Weighted Average Cost of Capital cannot be computed by the company.
Cost of Equity can be seen as the return rate paid to the investors as compensation for their investment in the company.
It is a crucial part for the company because it helps them analyze and compare the options they have when comparing avenues to raise finance.
Hence, it is rudimentary to determine and evaluate choices that the company has and the possible alternates they can opt for in the case where the cost of equity turns out to be very high.