Cost of Equity

Concept

Cost of Equity ($R_e$) is the return a company requires to decide if an investment meets capital return requirements. It is used by companies to determine which projects will yield the best return on investment. The cost of equity is determined by calculating the average amount of return earned by an investment, divided by the total amount of risk associated with that investment.

Formula

The formula for calculating the cost of equity is:

$$R_e = R_f + \beta (R_m - R_f)$$

Where:

• $R_e$ is the cost of equity.
• $R_f$ is the risk-free rate - this is typically the yield on a 10-year government bond.
• $\beta$ is the sensitivity of the expected excess asset returns to the expected excess market returns.
• $R_m$ is the expected return of the market.

Example

Let's say we have the following values:

• Risk-free rate ($R_f$): 2%
• $\beta$: 1.5
• Expected return of the market ($R_m$): 8%

Using the formula, we can calculate the cost of equity:

$$R_e = 2\% + 1.5 \times (8\% - 2\%) = 11\%$$

This means that the cost of equity is 11%.