About Cost of Equity
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 Cost of Equity using CAPM
The formula for calculating the cost of equity as per the CAPM model is as follows:
Rj = Rf + β(Rm – Rf)
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.
Interpretation / Analysis of Results
First of all, standalone figures of the cost of equity of a company have very less relevance. There are no scientific benchmarks for this metric. In general, we can say that the lower it is, the easier the viability of the business will be. We can get more or better inference when we have following other things along with it.
IRR of Projects and WACC
If we know what is the IRR of the projects of a company, we can calculate the WACC of its capital if it has debt capital too. WACC can be calculated using both costs, i.e., equity and debt. Then, we can simply compare the WACC to its IRR. If the IRR is more, the projects are acceptable.
Cost of Equity of Peer Companies
When the cost of equity of two shares in the same industry is compared, we can find a lot of inferences. If the cost of capital of Company A is 18% and Company B is 21%. We can say that Company B has a higher business risk perceived by the market. The management of the company can think on both sides. One, if the risk is really higher in Company B, compared to A. If yes, the company needs to evaluate how it can reduce that risk and lower its cost of capital. On the other hand, there is a possibility that Company B is earning higher profits also against taking higher risks.
- Cost of Equity – Capital Asset Pricing Model (CAPM)
- Cost of Debt Capital for Evaluating New Projects – Yield to Maturity
- WACC Calculation
- Advantages and Disadvantages of CAPM
- Importance and Use of Weighted Average Cost of Capital (WACC)
- Advantages and Disadvantages of Weighted Average Cost of Capital (WACC)