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Cost of equity

The cost of equity for a firm is the rate of return required for its shareholders.

Expanded Definition

Equity is not free to the company. Investors in the company expect a return and that return is the cost of the equity to the company. Because equity holders are subordinate to debt holders in cases of bankruptcy (they only get something if all the debt holders are satisfied first, and in a bankruptcy that usually means zilch), they require a higher return than debt holders do. Thus, equity is more expensive than debt (which is one reason that companies take on debt, to lower their average cost of capital).

Granted, it's not a cash outlay like interest is, but in an extreme situation, shareholders could force the company to pay out and generate some cash return for themselves. They own the company, after all. Think what happens when a hostile shareholder takes over, for instance.

Also, the cost is not fixed the same way interest on debt is, but a manager worth anything at all has a fairly good approximation of what it is.

Equity has a cost to the company, even if it's implicit. At worst, it's what the equity investor could have earned elsewhere in the next best thing, but gave up to invest here. Therefore, it should not be ignored when determining if the company is generating a high enough return on capital.

Calculation

One way to determine the cost of equity is to take the rate paid by a risk-free investment (such as the 10-year treasury) and add a risk premium to it. Research has shown that equity investors usually use a risk premium of 4% to 6% or so, and adding that to the 10-year rate of 4% or so gives a cost of equity of about 8% to 10%.

Many people use the volatility of the stock price relative to an index (its beta) to adjust the cost of capital, by adjusting the equity risk premium. (This is the capital asset pricing model, CAPM.)

For instance, if the volatility is 20% more than the index (beta = 1.20), then the cost of equity, including volatility of the stock, is 8.8% to 11.2% (4% * 1.2 + 4% = 8.8% and similarly for the other end).

For firms that pay a dividend, the cost of equity can be calculated with the following formula:

<math>Cost\ of\ Equity=\frac{Next\ Year's\ Dividend}{Share\ Price} + Dividend\ Growth\ Rate</math>

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