The cost of equity is the perceptional cost of investing equity capital in a business. Interest is the cost of utilizing borrowed money. For equity, there is no such direct cost available. Therefore, it is calculated based on the general principle of the risk-return trade-off.
The formula for calculating the cost of equity as per the CAPM model is as follows:
Rj = Rf + β(Rm – Rf)
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Rj = Cost of Equity / Required Rate of Return
Rf = Risk-free Rate of Return. Generally, it is the government’s treasury interest rate. We call it risk-free based on the premise that the government will never default on its financial commitments.
Rm = Expected Return from Market Portfolio. It is the expected return from an imaginary portfolio of shares where all the shares existing in the market are purchased in the ratio of the market capitalization of each.
β = Beta. It is the measure of risk. It represents the change in return of a particular company in response to a change in the Rm.