See Also:
Cost of Capital
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return
Capital Asset Pricing Model (CAPM)
Cost of EquityCost of equity, also known as the required rate of return on common stock, is the cost of raising funds from equity investors. It is the most challenging element in discount rate determination.
CAPMThe most popular method to calculate cost of equity is Capital Asset Pricing Model (CAPM). The CAPM states that the expected return on an asset is related to its risk as measured by beta:
E(Ri) = Rf + ßi * (E(Rm) – Rf)
Or = Rf + ßi * (risk premium)
Where
E(Ri) = the expected return on asset given its beta
Rf = the risk-free rate of return
E(Rm) = the expected return on the market portfolio
ßi = the asset’s sensitivity to returns on the market portfolio
E(Rm) – Rf = market risk premium, the expected return on the market minus the risk free rate.
The CAPM states that the expected return on an asset given its beta is the risk-free rate plus a risk premium equal to beta times the market risk premium.
Beta is always estimated based on an equity market index. The beta of a company is determined by three variables: 1) the type business the company is in, 2) the degree of operating leverage of the company, and 3) the company’s financial leverage.
Risk-free rate of return is determined by short-term government debt rate (such as a 30-day T-bill rate, or a long-term government bond yield to maturity) and when cash flows come due. Risk-free rate is defined as the expected returns with certainty.
Risk premium indicates the “extra return” that would be demanded by investors for shifting their money from riskless investment to an average risk investment. It is a function of how risk-averse investors are and how risky they perceive investment opportunities compared with a riskless investment.
Cost of Equity CalculationExample: a company has a beta of 0.5, a historical risk premium of 6%, and a risk-free rate of 5.25%. The required rate of return of this company according to the CAPM is: 5.25% + (0.5 * 6%) = 8.25%