Explained: What is meant by Cost of Equity?

Companies require funds for various reasons ranging from fulfilling working capital requirements, purchasing property, plant and equipment to financing growth and expansion aspirations. When companies raise capital by issuing equity, the cost they incur is called the cost of equity.

Also, when investors lend funds to companies by way of equity, they expect a certain minimum return to justify their investments. This rate of return is based on the future cash flows that investors expect to receive. And since companies are not contractually obligated to make any payments to their shareholders for the use of their funds, these cashflow expectations differ from investor to investor, making it difficult to estimate the cost of equity.

Owing to this, the company’s cost of equity is often used as a substitute for the investors’ minimum required rate of return because companies try to raise capital at the lowest possible cost.

There are two ways of estimating the cost of equity:

1. Dividend Discount Model (DDM)

This model estimates the cost of equity by using the following formula -

Cost of equity (Ke) = DPS ÷ CMV + GRD,

Where,

DPS= dividends per share

CMV= current market value of the stock

And GRD= growth rate of dividends.

2. Capital Asset Pricing Model (CAPM)

This model estimates the cost of equity by using the following formula -

Cost of Equity (Ke) = Risk-Free Rate of Return + Beta × (Market Rate of Return – Risk-Free Rate of Return)

Where,

Risk-Free Rate of Return= Return offered on Government securities

Beta= Volatility of the stock.

Bottomline-

In simple terms, the cost of equity can be described as the minimum expected rate of return that a company must offer its investors to justify the latter’s investments in the former.