Cost of Equity- Calculation Theory part

 

Cost of Equity

Meaning:-

Cost of Equity refers to the rate of return that a company is expected to provide to its equity shareholders for the risk they undertake by investing in the company. In simple terms, it is the minimum return that shareholders expect from their investment. It is an important component of the Weighted Average Cost of Capital (WACC) and is used in investment decisions, valuation, and capital structure decisions.

Example

If shareholders invest ₹10, 00,000 in a company and expect a return of 12%, then:

Cost of Equity = 12%

The company should ideally earn at least this return on the funds provided by equity shareholders.

Methods of Calculating Cost of Equity

There are three commonly used methods:

1.        Dividend Price Approach

2.        Dividend Growth Model

3.        Earnings Per Share( EPS) method

4.        Capital Asset pricing  Model

1. Dividend Price Approach

This method is based on the relationship between the expected dividend and the market price of the equity share.

Formula:

Ke=D/NP ×100

 Where:

  • Ke = Cost of Equity
  • D = Expected annual dividend per share
  • NP= Net Proceeds

2. Dividend Growth Model

When dividends are expected to grow at a constant rate, the Dividend Growth Model or Gordon Growth Model can be used.

Formula:

Ke=D1/P0+g

Where:

  • D = Expected dividend next year
  • NP = Current market price
  • g = Expected growth rate of dividend

3. Earning Price Method

            Ke= (EPS/NP)X100

           

4. Capital Asset Pricing Model (CAPM)

CAPM determines the cost of equity based on the risk-free rate, systematic risk (beta), and market risk premium.

Formula:

Ke=Rf+β(Rm−Rf)K_e = R_f+\beta(R_m-R_f)

Where:

  • KeK_e = Cost of Equity
  • RfR_f = Risk-free rate of return
  • β\beta = Beta of the company
  • RmR_m = Expected market return
  • Rm−RfR_m-R_f = Market risk premium

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