Cost Of Equity

Reviewed by Vineeth | Updated on Aug 27, 2020

Introduction

The cost of equity is defined as the returns that a firm has to decide when the capital return requirements are met by an investment. Companies generally utilise this as a capital budgeting threshold for the requisite rate of returns. A company’s cost of capital represents the price that the markets demand in turn for owning the capital asset and assuming the ownership risks involved. The conventional formula to obtain the equity cost is the model of dividend capitalisation and the model of capital asset pricing model.

Breaking Down Cost of Equity

The cost of equity points, depending on the partied involved, refers to the two individual concepts. In the case of you being an investor, the cost of equity is the return rate that is needed on an equity investment. In the case of you being a company, then the cost of equity will go on to determining the rate of return that is needed in a certain investment or project.

There are two methods through which an organisation can collect capital, and they are debt and equity. For companies, the debt method is cheaper. However, the company has to repay what it raised through this method. On the other hand, the equity method requires no repayment. However, the cost involved in equity way of repayment is costlier as there are tax implications that pushes the cost towards the north. The fact the equity method of raising capital comes at a higher cost, the return it provides is also higher.

Cost of Capital and Cost of Equity

The cost of capital is the overall expenditure of capital pooling, considering both the cost of debt and equity. A well-performing and stable organisation would typically keep the cost of capital on the lower side. In order to determine the cost of capital, the cost of debt and cost of equity will have to considered and must be added. The cost of capital is more often than not determined by the method of the weighted average cost of capital.