Cost of Equity
The cost of equity is the rate of return investors receive for an investment to compensate them for the risk they are undertaking.
Updated: November 27, 2023
![](https://www.saasuncovered.com/assets/media/1836716858cost-of-equity.jpg)
The cost of equity is the rate of return investors receive for an investment to compensate them for the risk they are undertaking. The return firms pay it to their equity investors or shareholders as they grow capital.
Equity management software, sometimes referred to as cap table management software is used by companies to administer equity or its assets minus its liabilities. The complex processes of issuing equity and its potential cost is tracked and managed by these tools.
Investors should know the cost of equity to ensure their investments are worthwhile and beneficial. Investors may look for their investments to increase by the cost of equity at a minimum in terms of stock valuation.
The dividend capitalization model or the dividend discount model and the capital asset pricing model (CAPM) are two ways to calculate the cost of equity. The calculations for the same investment may differ as different variables are used by these two calculations. However, the risk of an investment can be evaluated by both models.
Cost of equity = (D1 / P0) + g in the dividend capitalization model where, D1 is the yearly dividends per share or the total number of dividends that one share earns in one year, P0 is the current price of one share and g is the dividend growth rate.
Expected return on investment = Rf + βi (E(Rm) - Rf) in the capital asset pricing model (CAPM), where Rf, otherwise known as the risk-free rate is the interest rate of an investment with zero risk, βi is the beta risk or volatility of the investment compared to the wider market and (E(Rm) - Rf) refers to the overall risk of investing in the stock market.
Why is the cost of equity important?
- Investor Attraction
- Capital Budgeting
- Stock Valuation
- Cost of Capital Calculation
- Setting Financial Goals
- Risk Assessment
- Dividend Policy
- Market Perception
- Investor Relations
- Debt-Equity Decision Making
- Strategic Planning
- Share Price Stability