Cost of Equity
Cost of equity refers to the return that investors require for holding a company's stock. It is a key component in determining a company's overall cost of capital and is used in various financial calculations, such as valuation and investment decision-making. The cost of equity is influenced by factors such as the company's risk profile, market conditions, and investor expectations.
6 Key excerpts on "Cost of Equity"
eBook - ePubInvestment Valuation
Tools and Techniques for Determining the Value of any Asset, University Edition
- Aswath Damodaran(Author)
- 2012(Publication Date)
- Wiley(Publisher)
...Chapter 4 argued that the expected return for equity investors would include a premium for the equity risk in the investment. We label this expected return the Cost of Equity. Similarly, the expected return that lenders hope to make on their investments includes a premium for default risk, and we call that expected return the cost of debt. If we consider all of the financing that the firm takes on, the composite cost of financing will be a weighted average of the costs of equity and debt, and this weighted cost is the cost of capital. The chapter begins by estimating the equity risk in a firm and using the equity risk to estimate the Cost of Equity, and follows up by measuring the default risk to estimate a cost of debt. It concludes by determining the weights we should attach to each of these costs to arrive at a cost of capital. Cost of Equity The Cost of Equity is the rate of return investors require on an equity investment in a firm. The risk and return models described in Chapter 4 need a riskless rate and a risk premium (in the CAPM) or premiums (in the APM and multifactor models), which were estimated in the last chapter. They also need measures of a firm's exposure to market risk in the form of betas. These inputs are used to arrive at an expected return on an equity investment: This expected return to equity investors includes compensation for the market risk in the investment and is the Cost of Equity. This section concentrates on the estimation of the beta of a firm. While much of the discussion is directed at the CAPM, it can be extended to apply to the arbitrage pricing and multifactor models, as well. Betas In the CAPM, the beta of an investment is the risk that the investment adds to a market portfolio. In the APM and multifactor model, the betas of the investment relative to each factor have to be measured...
eBook - ePub- Terence C.M. Tse(Author)
- 2017(Publication Date)
- Routledge(Publisher)
...Shareholders’ equity is considered the most “junior” type of financing: being junior, shareholders are paid last. Being junior also means that, if the company goes bankrupt, the proceeds from the sale of the company’s assets will go first to paying back the debtholders in full. Only if there is anything left will it then go towards compensating the shareholders. Two important insights emerge here. First, in just the same way as the cost of debt and the return that the lenders require are two sides of the same coin, the Cost of Equity and the return needed by the shareholders represent different perspectives on the same matter, as shown in Table 6.1. Second, given that the shareholders will always ask for a higher return as a result of the higher risk they face, the cost of using equity will always be higher than the cost of debt, i.e.: Cost of Equity > Cost of debt Or simply: r E > r D Let’s now look at how to calculate the Cost of Equity. Table 6.1 Two sides of the same coin (bank loans, bonds and equity) From the company’s viewpoint … From the investors’ viewpoint … Bank loan: The interest rate is the … Cost of using the bank loan Return needed by the bank Bond: The YTM is the … Cost of using the bond Return needed by the bondholder/investor Equity: The dividend growth model or the CAPM (both described below) leads to the … Cost of Equity Return needed by the shareholders Determining the Cost of Equity The Cost of Equity can be established by figuring out the return that the shareholders would want. There are generally two possible methods. Method 1: dividend growth model The first approach is the dividend growth model (also called the Gordon-Shapiro model). The best starting point for understanding this model is to look at how shareholders can make money from investing in a company. Typically, they do so from 1) receiving dividends from the company and 2) selling their shares at a price higher than the price they paid for them in the first place (i.e...
eBook - ePubCorporate Finance
A Practical Approach
- Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
- 2012(Publication Date)
- Wiley(Publisher)
...Arriving at a cost of capital estimate requires a host of assumptions and estimates. Another challenge is that the cost of capital that is appropriately applied to a specific investment depends on the characteristics of that investment: The riskier the investment’s cash flows, the greater its cost of capital. In reality, a company must estimate project-specific costs of capital. What is often done, however, is to estimate the cost of capital for the company as a whole and then adjust this overall corporate cost of capital upward or downward to reflect the risk of the contemplated project relative to the company’s average project. This chapter is organized as follows: In the next section, we introduce the cost of capital and its basic computation. Section 3 presents a selection of methods for estimating the costs of the various sources of capital, and Section 4 discusses issues an analyst faces in using the cost of capital. Section 5 summarizes the chapter. 2. COST OF CAPITAL The cost of capital is the rate of return that the suppliers of capital—bondholders and owners—require as compensation for their contribution of capital. Another way of looking at the cost of capital is that it is the opportunity cost of funds for the suppliers of capital: A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. A company typically has several alternatives for raising capital, including issuing equity, debt, and instruments that share characteristics of debt and equity. Each source selected becomes a component of the company’s funding and has a cost (required rate of return) that may be called a component cost of capital. Because we are using the cost of capital in the evaluation of investment opportunities, we are dealing with a marginal cost—what it would cost to raise additional funds for the potential investment project...
eBook - ePub- Alan J. Baker(Author)
- 2018(Publication Date)
- Routledge(Publisher)
...For firm x the Cost of Equity, k x * — the required level of expected return on equity investment — would be estimated as follows: k ¯ x * = r ¯ f + β x (R ¯ M − r ¯ f) (xx) in which r f and R M now represent, respectively, management’s estimates of the average future values of the risk-free interest rate and the rate of return on the market portfolio, and β x is the estimated beta coefficient for firm x. In two ways this represents a move towards the traditional approach to the Cost of Equity. First, the value of k x * is accepted as the Cost of Equity for firm x rather than for any single project, subject to the qualification that projects undertaken by the firm do not significantly affect its systematic risk, β x. Second, the cost of capital is seen as influenced by the average anticipated performance of the market over a lengthy period of time, in much the same way as the traditional Cost of Equity can be interpreted as the rate of return equity investors can expect to earn over the long term (Merrett and Sykes, 1963, pp. 72-4, and 1963a). The attempt to link the return on each project to the performance of the market portfolio in the ultra-short period (or succession of short periods) gives way to a much-diluted compromise version of a CAPM criterion. A more ambitious gap-bridging exercise is to try to narrow the differences between traditional and portfolio valuation models. We have referred earlier to such factors as transactions costs and bankruptcy costs as possible reasons for a firm’s equity being valued not only on the basis of its systematic or undiversiflable risk; and these qualifications to the pure CAPM represent something of a move towards the traditional position. The two views can be brought even closer together by a determined effort to ‘get behind’ the expected end-period value of a risky security in the portfolio valuation model, i.e. P 1 in equation (ii). It can be shown (Baker, 1978, pp...
eBook - ePub- Jerald E. Pinto(Author)
- 2020(Publication Date)
- Wiley(Publisher)
...The Required Return on Equity With means to estimate the equity risk premium in hand, the analyst can estimate the required return on the equity of a particular issuer. The choices include the following: the CAPM; a multifactor model such as the Fama–French or related models; and a build-up method, such as the bond yield plus risk premium method. 4.1. The Capital Asset Pricing Model The CAPM is an equation for required return that should hold in equilibrium (the condition in which supply equals demand) if the model’s assumptions are met; among the key assumptions are that investors are risk averse and that they make investment decisions based on the mean return and variance of returns of their total portfolio. The chief insight of the model is that investors evaluate the risk of an asset in terms of the asset’s contribution to the systematic risk of their total portfolio (systematic risk is risk that cannot be shed by portfolio diversification). Because the CAPM provides an economically grounded and relatively objective procedure for required return estimation, it has been widely used in valuation. The expression for the CAPM that is used in practice was given earlier as Equation 4 : 33 Required return on share i = Current expected risk-free return + β 1 (Equity risk premium) For example, if the current expected risk-free return is 3 percent, the asset’s beta is 1.20, and the equity risk premium is 4.5 percent, then the asset’s required return is Required return on share i = 0.030 + 1.20(0.045) = 0.084 or 8.4 percent The asset’s beta measures its market or systematic risk, which in theory is the sensitivity of its returns to the returns on the “market portfolio” of risky assets. Concretely, beta equals the covariance of returns with the returns on the market portfolio divided by the market portfolio’s variance of returns. In typical practice for equity valuation, the market portfolio is represented by a broad value-weighted equity market index...
eBook - ePub- Brümmer LM, Hall JH, Du Toit E(Authors)
- 2017(Publication Date)
- Van Schaik Publishers(Publisher)
...183 11 Valuation and the required rate of return Learning outcomes After studying this chapter, you should understand the principles of valuation be able to master the basic valuation formula be able to calculate the cost of capital be able to calculate the cost of owners’ equity be able to calculate the cost of preference share capital be able to calculate the cost of long-term debt capital understand the weighted average cost of capital know how to apply the weighted average cost of capital in developing an organisation’s capital structure. Introduction In Chapter 10, the terms “cost of capital” and “required rate of return” were used frequently. These two terms are often used interchangeably. In one sense, they mean virtually the same thing, yet they can mean different things, depending on the context in which they are being used. In this chapter, we shall briefly discuss these concepts because the cost of capital, especially the weighted average cost of capital (WACC), plays a role in determining the discount rate in the net present value (NPV) method. Provided enough information can be obtained from the financial statements of a prospective debtor or investment project (e.g. the purchase of shares in an organisation), the task of calculating the WACC should be relatively easy. Besides providing a suitable discount rate, the WACC can also indicate whether an organisation is operating profitably or not. This can be done by comparing the organisation’s current rate of return on investment (ROI) with its WACC. For an organisation to be profitable, its ROI must always be greater than its WACC. 184 Apart from the information already mentioned, the WACC also provides the means for developing an organisation’s capital structure. Refer to the quarter marked Q.1 in LJE Ltd’s Statement of Financial Position in Chapter 4. The capital structure is not a haphazard conglomeration of capital items, but a very carefully planned structure...
