Meaning Of Cost Of Equity (Ke)
The cost of equity is the rate of return that an investor requires in exchange for investing in a company, or the rate of return that a company must receive in exchange for making an investment or undertaking a project. It provides an answer to the question of whether taking a risk on equity is worthwhile. It is also used, along with the cost of debt, in the calculation of a company's weighted average cost of capital, also known as WACC, or weighted average cost of capital.
It is possible to calculate the cost of equity in two ways: by using the dividend capitalization model or by using the capital asset pricing model (CAPM). However, neither method is completely accurate because the return on investment is a calculation based on predictions about the stock market; however, they can both assist you in making informed investment decisions.
Key Components of Cost of Equity
Risk-Free Rate (rf)
The risk-free rate (rf) is a term that refers to the yield on long-term government securities that are not subject to default.
Theoretically, government-issued bonds are considered risk-free because the government has the ability to print additional money at their discretion if it is deemed necessary to avoid defaulting on the bond.
Alternatively, beta is defined as the degree to which a specific security's price movements are affected by the systematic risk of the market as a whole. In other words, beta captures the relationship between the price movements of a specific company's stock and the overall market (e.g. S&P 500).
Generally speaking, the risk associated with beta can be divided into two categories:
Unsystematic Risk: Also known as "company-specific risk," unsystematic risk can be mitigated through diversification and is therefore underappreciated and ignored.
Systematic Risk: On the other hand, systematic risk (also known as market risk) is referred to as an undiversifiable risk, and as implied by the name, a company's sensitivity to systematic risk cannot be reduced through diversification of its assets and liabilities.
According to a general rule, the greater the beta, the greater the cost of equity investment (and vice versa).
Because systematic risk does not diminish even when the portfolio is further diversified, investors demand greater compensation (i.e., higher potential returns) in exchange for taking on the additional risk.
Because of the increased sensitivity to market fluctuations, increased volatility should result in higher potential investor returns, according to the rationale behind the strategy.
Equity Risk Premium (ERP)
When it comes to calculating the cost of equity, the final component is referred to as the equity risk premium (ERP), which is the additional risk associated with investing in equities rather than risk-free securities, such as bonds.
Equity Risk Premium Formula
Equity Risk Premium = Expected Market Rate - Risk Free Rate
In light of the fact that the possibility of losing invested capital in the stock market is significantly greater than the possibility of losing invested capital in risk-free government securities, there must be an economic incentive for investors to place their capital in the public markets, which is reflected in the existence of the equity risk premium.
How to Calculate of Cost of Equity
The CAPM considers the riskiness of an investment in relation to the overall market. Because of the estimations made during the calculation, the model is less accurate (because it uses historical information).
E(Ri) = Rf + βi * [E(Rm) – Rf]
E(Ri) = Expected return on asset i
Rf = Risk-free rate of return
βi = Beta of asset i
E(Rm) = Expected market return
Dividend Capitalization Model
The Dividend Capitalization Model is only applicable to companies that pay dividends, and it makes the assumption that dividends will grow at a constant rate in the future. The model does not take into account investment risk in the same way that the CAPM does, for example (since CAPM requires beta).
Dividend Capitalization Formula:
Re = (D1 / P0) + g
Re = Cost of Equity
D1 = Dividends/share next year
P0 = Current share price
g = Dividend growth rate
Re = (D1 / P0) + g
Interpretation of Cost Of Equity
Depending on which party is involved, the term "cost of equity" can refer to two distinct concepts. As an investor, the cost of equity is the rate of return required on a capital expenditure made in the form of equity. For a corporation, the cost of equity is the factor that determines the rate of return required on a particular project or investment.
A company can raise capital in two ways: through debt or through equity financing. Debt is less expensive, but the company is responsible for repaying it. Although equity does not have to be repaid, it is generally more expensive than debt capital due to the tax benefits associated with interest payments. Because the cost of equity is higher than the cost of debt, it typically generates a higher rate of return than debt.
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