Cost of equity
Encyclopedia
In finance
, the cost of equity is the return (often expressed as a rate of return
) a firm theoretically pays to its equity investors, i.e., shareholder
s, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest
and equity investors seek dividends and/or appreciation in the value of their investment (capital gain
). From a firm's perspective, they must pay for the capital it obtains from others, which is called its cost of capital
. Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two kinds of capital sources.
While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various models for estimating a particular firm's cost of equity such as the Capital Asset Pricing Model
, or CAPM. Another method is derived from the Gordon Model
, which is a discounted cash flow model based on dividend returns and eventual capital return from the sale of the investment. Moreover, a firm's overall cost of capital, which consists of the two types of capital costs, can be estimated using the weighted average cost of capital
model.
According to finance theory, as a firm's risk
increases/decreases its cost of capital increases/decreases. This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere.
Knowing a firm's cost of capital is needed in order to make better decisions. Managers make capital budgeting
decisions while capital providers make decisions about lending and investment
. Such decisions can be made after quantitative analysis that typically uses a firm's cost of capital as a model input.
Finance
"Finance" is often defined simply as the management of money or “funds” management Modern finance, however, is a family of business activity that includes the origination, marketing, and management of cash and money surrogates through a variety of capital accounts, instruments, and markets created...
, the cost of equity is the return (often expressed as a rate of return
Rate of return
In finance, rate of return , also known as return on investment , rate of profit or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or...
) a firm theoretically pays to its equity investors, i.e., shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with interest
Interest
Interest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
and equity investors seek dividends and/or appreciation in the value of their investment (capital gain
Capital gain
A capital gain is a profit that results from investments into a capital asset, such as stocks, bonds or real estate, which exceeds the purchase price. It is the difference between a higher selling price and a lower purchase price, resulting in a financial gain for the investor...
). From a firm's perspective, they must pay for the capital it obtains from others, which is called its cost of capital
Cost of capital
The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
. Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two kinds of capital sources.
While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various models for estimating a particular firm's cost of equity such as the Capital Asset Pricing Model
Capital asset pricing model
In finance, the capital asset pricing model is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk...
, or CAPM. Another method is derived from the Gordon Model
Gordon model
The Gordon growth model is a variant of the discounted cash flow model, a method for valuing a stock or business. Often used to provide difficult-to-resolve valuation issues for litigation, tax planning, and business transactions that don't have an explicit market value. It is named after Myron J....
, which is a discounted cash flow model based on dividend returns and eventual capital return from the sale of the investment. Moreover, a firm's overall cost of capital, which consists of the two types of capital costs, can be estimated using the weighted average cost of capital
Weighted average cost of capital
The weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
model.
According to finance theory, as a firm's risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
increases/decreases its cost of capital increases/decreases. This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere.
Knowing a firm's cost of capital is needed in order to make better decisions. Managers make capital budgeting
Capital budgeting
Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing...
decisions while capital providers make decisions about lending and investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
. Such decisions can be made after quantitative analysis that typically uses a firm's cost of capital as a model input.
See also
- Cost of capitalCost of capitalThe cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds , or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities"...
- Cost of debt
- Return on equityReturn on equityReturn on equity measures the rate of return on the ownership interest of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity . ROE shows how well a company uses investment funds to generate earnings growth...
- Weighted average cost of capitalWeighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....