8.3 : Cost of Equity

In finance, the cost of equity is the return a firm theoretically pays to its shareholders to compensate for the risk they take by investing their capital. Companies need external capital to operate and grow, and the cost of equity helps determine the rate of return required to satisfy equity investors.

This rate represents the shareholders' expectations for the minimum return they should earn, considering the risks involved and the opportunity cost of investing elsewhere. For example, if an individual like Alex invests in a new start-up, he expects a return that compensates for the risk of investing, as his capital could have been used in other ventures. The cost of equity is the minimum return that would make Alex's investment worthwhile.

Companies calculate the cost of equity using models like the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate, the stock's volatility (beta) relative to the market, and the expected market return above the risk-free rate.

Understanding the cost of equity helps businesses evaluate the financial viability of projects, ensuring they generate enough returns to satisfy investors and promote long-term growth.