Business, Legal & Accounting Glossary
The cost of equity is the minimum rate of return that a business or organization must offer investors or owners to offset their wait for a return on investment and for assuming some level of risk. There are conflicting approaches to estimating the cost of equity and cost of equity percentages. The traditional formula for calculating the cost of equity is the dividend capitalization model (dividend per share/price per share + growth rate of dividends). With the dividend capitalization model, the cost of equity can be calculated for a given industry based on the current rate of return. A higher cost of equity usually signifies a higher risk industry that commands a higher return for the increased risk. The cost of equity can also be determined by the capital asset pricing model (CAPM). Calculating the cost of equity using CAPM is often more difficult than using the dividend capitalization model for determining the cost of equity. The cost of equity does not show up on a company’s income statement. However, the cost of equity is never free.
The cost of equity, in broad terms, is the compensation that the market demands in exchange for owning and bearing the risk of a company’s equity. From a business’s standpoint, the projected rate of return on equity is referred to as the cost of equity.
The capital asset pricing model is the most frequently used approach for estimating the cost of equity. It explicitly accounts for the riskiness of an investment. It does, however, rely implicitly on empirical data from the historical performance of public corporations. Calculating the firm’s cost of capital and, ultimately, its worth requires determining an appropriate cost of equity.
This is a complex and time-consuming calculation that private mid-market firm owners rarely perform. In general, the following are the projected costs of equity for enterprises of various sizes and stages of the business life cycle:
Rate of Return on Equity
Cost of Debt
Weighted Average Cost of Capital
Return On Capital
Internal Rate of Return
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This glossary post was last updated: 26th January, 2022 | 0 Views.