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# Cost of Equity Definition, Formula, and Example

## What Is the Cost of Equity?

Cost of equity refers to the return on investment that shareholders expect in exchange for investing in a company’s common stock. In other words, it is the compensation that investors demand for taking on the risk of investing in a company’s equity.

Knowing the cost of equity is important because it helps businesses make investment decisions and evaluate management performance. The most common method for calculating the cost of equity is the Capital Asset Pricing Model (CAPM), which takes into account the risk-free rate of return, the market risk premium, and the beta of the company’s stock.

The risk-free rate of return is the return on investment for a risk-free asset, such as a government bond. Beta is a measure of the volatility of a company’s stock compared to the overall market. The market risk premium represents the extra compensation investors require for investing in stocks instead of risk-free assets.

## Cost of Equity Formula

The most commonly used formula for calculating the cost of equity is the Capital Asset Pricing Model (CAPM), which is as follows:

Cost of Equity = Risk-Free Rate of Return + Beta (Market Risk Premium)

or

Cost of Equity = Rf + β (Rm – Rf)

Where:

• Rf is the risk-free rate of return
• β is the beta of the company’s stock
• Rm is the expected return on the market
• Rm – Rf is the market risk premium

## Example of Cost of Equity

#### Example 1: Suppose a company has a beta of 1.5, a risk-free rate of return of 3%, and the market risk premium is 10%. How to calculated the company’s cost of equity?

Cost of Equity = Risk-Free Rate of Return + Beta (Market Risk Premium)

= 3% + 1.5 (10%)

= 3% + 15%

= 18%

#### Example 2: Suppose a company has a beta of 0.8, a risk-free rate of return of 2%, and the market risk premium is 9%. How to calculated the company’s cost of equity?

Cost of Equity = Risk-Free Rate of Return + Beta (Market Risk Premium)

= 2% + 0.8 (9%)

= 2% + 7.2%

= 9.2%

#### Example 3: Acompany has a beta of 1.1, a risk-free rate of return of 4%, and the market risk premium is 8%. How to calculated the company’s cost of equity?

Cost of Equity = Risk-Free Rate of Return + Beta (Market Risk Premium)

= 4% + 1.1 (8%)

= 4% + 8.8%

= 12.8%

### Frequently Asked Questions – (FAQs)

#### Q: What is the cost of equity?

A: The cost of equity is the rate of return that investors require to invest in a company’s common stock. It represents the compensation that investors expect to receive for the risks they are taking by investing in the company’s equity.

#### Q: Why is the cost of equity higher than the cost of debt?

A: The cost of equity is typically higher than the cost of debt because equity investors have a higher risk of losing their investment if the company does not perform well.

#### Q: How is the cost of equity calculated?

A: The most commonly used formula for calculating the cost of equity is the Capital Asset Pricing Model (CAPM).

#### Q: What is the risk-free rate of return?

A: The risk-free rate of return is the rate of return on a risk-free investment, such as a government bond. It is the rate of return an investor would expect to earn without taking any risk.

#### Q: Why is the cost of equity important?

A: The cost of equity is an important because it is used to calculate the company’s cost of capital and to make investment decisions. It is also used to evaluate the performance of a company’s management.