8.4 : Calculating Cost of Equity

Calculating the cost of equity is essential for businesses to assess the return required to compensate investors for their risk.

One common method to calculate this is the Capital Asset Pricing Model or CAPM, which defines the cost of equity as the risk-free rate plus the equity beta times the market risk premium.

Consider a sports equipment manufacturing company evaluating its cost of equity.

The risk-free rate is three percent, reflecting the return on government bonds.

The company's equity beta, which measures its stock's volatility relative to the market, is one point two.

The average return that investors expect from the market is eight percent.

So, the market risk premium, the expected market return minus the risk-free rate, is five percent.

Considering the figures of the risk-free rate, beta, and market risk premium, the cost of equity is calculated at nine percent using the CAPM formula.

This means the company must earn at least a nine percent return on its equity investments to compensate its investors adequately for the risks they are taking.

The cost of equity is critical for evaluating new investment projects, ensuring sustainable growth and investor confidence.