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What is Cost of Equity?

What is Cost of Equity?

The cost of equity is the return ( rate of return) a company  pays to its equity investors or shareholders to compensate for the risk they undertake by investing their capital.

The equity investors seek dividends and/or appreciation in the value of their investment (capital gain on share price). The current cost of equity is unobservable and must be estimated.

There are various models for estimating a particular company’s cost of equity as follows:

  • We use thecapital asset pricing model ( CAPM). Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of Return).
  • TheGordon Model, which is a discounted cash flow model based on dividend returns and eventual capital return from the sale of the investment.
  • The Bond Yield Plus Risk Premium (BYPRP), where a subjective risk premium is added to the firm’s long-term debt interest rate.

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