Cost of Equity

In finance, the 'Cost of Equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk.

The cost of equity capital for a particular company is the rate of return on investment that is required by the company's ordinary shareholders. The return consists both ofdividend and capital gains, e.g. increases in the share price. The returns are expected future returns, not historical returns, and so the returns on equity can be expressed as the anticipated dividends on the shares every year in perpetuity. The cost of equity is then the cost of capital which will equate the current market price of the share with the discounted value of all future dividends in Perpetuity

The cost of equity reflects the Opportunity Cost of investment for individual shareholders. It will vary from company to company because of the differences in the business risk and financial or gearing risk of different companies.

${\text{Cost of Equity}}={\frac {\text{Next Year's Dividends and Equity Appreciation per Share}}{\text{Current Market Value of Stock}}}\ +{\text{Growth Rate of Dividends}}$

There are also a variety of other ways to estimate the cost of equity. For example, using the CAPM Model, the cost of equity is the product of the Market Risk Premium and the equity's beta plus the risk-free interest rate:

${\text{Cost of Equity}}={\text{Market Risk Premium}}*{\text{Equity Beta + Riskless Rate}}$

Cost of equity = Risk free rate of return + Premium expected for risk Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) Where Beta= sensitivity to movements in the relevant market: $E_{s}=R_{f}+\beta _{s}(R_{m}-R_{f})$

Where:

$E_{s}$

   The expected return for a security

$R_{f}$

   The expected risk-free return in that market (government bond yield)

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   The sensitivity to market risk for the security

$R_{m}$

   The historical return of the stock market/ equity market

$(R_{m}-R_{f})$

   The risk premium of market assets over risk free assets.

The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.