Cost of Equity: Definition, Formula & Calculation
One of the most effective ways for small businesses and startups to grow and expand is to attract new investors. The investors will then inject capital into the business so it can achieve its goals, ultimately earning the investor a profit. But when a company has shareholders, it means that there can be a need to calculate the rate of return it will receive.Ā
Doing this allows for a deeper understanding of where the business stands in terms of equity and it can aid in making more informed business decisions in the future. Continue reading to learn what the cost of equity is and how it works. We will also cover the different formulas you can use and some frequently asked questions.
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KEY TAKEAWAYS
- Cost of equity helps show how much it costs to issue shares to business investors.
- You usually use money funded by equity to invest in your business. The cost of equity calculation should be lower than the profit you may on the related purchases.
- You can calculate the cost of equity using two formulas. One takes dividends into account and the other is for businesses that do not pay dividends to shareholders.
Cost of Equity Definition
Cost of equity represents a calculation that businesses use to determine the rate of return to shareholders. Investors lend money to a business in return for equity in the business. Shares are typically used to represent the equity, and investors expect to make a profit on their investment. One way to reward investors is by paying dividends a couple of times per year.
But equity holders also expect their investment to make the business more profitable and thus more valuable. This means increasing the value of shares as a way of paying back investors. Business owners can use the cost of equity formula to decide whether equity investments are worthwhile. There are two models for calculating the cost of equity. One is the dividend capitalization model and the other is the capital asset pricing model (CAPM).
Cost of Equity Formulas
Dividend Capitalization Model
Business owners can use this model to calculate the cost of equity using three variables:
- Dividends per share for the coming year (DPS)
- Current market value of the shares (CMV)
- Growth rate of the dividends (GRD)
Divide the dividends per share by the current market value. Then add the growth rate. The dividend capitalization model formula looks like this: (DPS / CMV) + GRD.
A high dividend growth rate means you’re paying more back to shareholders. Offering money is not a risk-free investment for investors. The systematic risk means they expect to earn a high rate of dividends. Capital from equity investors may cost a company more than debt financing. Debt rates are often lower than return for equity investors.
Cost Equity Example Using Dividend Capitalization
For this example, our company plans to pay a $6 dividend next year. Each share currently has a market value of $30. The company expects the growth in dividends to be 9% or (.09). The formula is: .2 (or $6 / $30) + .09 = .29 (or 29%). So the cost of equity is 29%.
This method is exclusively used for companies that plan to pay dividends. Not all companies pay dividends to their shareholders.
The CAPM (Capital Asset Pricing Model) Formula
Investments like treasury bonds are risk-free. Beta represents the measure of risk as a company’s stock prices regress. Higher volatility usually correlates with higher beta and higher relative risk compared to the market return in general. In this formula, the current average market rate is the market rate of return. A higher cost of equity would usually indicate a higher risk for companies.
Cost Equity Example Using CAPM
For this example, our company has a 9% rate of return on the S&P 500. It also has a beta of 1.2, meaning it is slightly more volatile than the average market. The present risk-free rate is 1%. With these numbers, you can use the CAPM to calculate the cost of equity. The formula is: 1 + 1.2 * (9-1) = 10.6%. For our fictional company, the cost of equity financing is 10.6%. This rate is comparable to an interest rate you would pay on a loan.
Comparing the Cost of Equity to the Cost of Debt
Equity often costs a business more than debt costs. Equity investors receive more generous compensation because investors are taking a greater risk than lenders. With equity, there is no return guarantee. A business could go bankrupt and cost individual investors money. Rules of equity and debt are:
- A business pays lenders before equity investors
- A business guarantees payments to lenders, but not to equity investors
- A lender may use collateral to secure business debt, while equity is not secured
- Lenders have a higher guarantee and thus have a lower rate of return
Comparing Cost of Equity to Cost of Capital
Cost of equity is only part of the equation. Cost of debt is the other part. The cost of capital looks at these two pieces as one big picture. Stable companies usually have lower capital costs. To reach the capital cost, you must weigh both the cost of capital and the cost of debt. Then add them together. Weighting means that you average your overall debts together and your overall equity together.
Keep in mind that calculating cost of equity once only offers a small glimpse at the overall expense. It is important to calculate cost of equity over time to identify trends and areas for improvement.
Summary
Cost of equity calculates the cost of issuing shares to investors. This formula can help you determine whether equity financing or debt financing is better for your business. It is important to take into account whether or not you pay dividends when calculating cost of equity. Best practice is to keep the cost of equity lower than your revenue. This keeps your business profitable.
FAQs on Cost of Equity
The cost of equity determines the average cost of issuing shares to investors.
When you know the cost of equity, you can make sure your business stays profitable. Ideally, you use equity capital to improve your business and make it more profitable. If the cost of issuing equity to investors is higher than the profit margin, you may need to reevaluate.
This calculation should help inform business decisions. Business owners can weigh the pros and cons of debt versus equity to raise capital. Ideally, the profit margins stay above the cost of equity.
The value usually falls between 6% and 8% with a U.S. average of 7%. A lower cost of equity may indicate a stable, well-performing company.
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