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Cost of Equity – Definition

Cost of Equity Definition

The cost of equity of a company is the rate of return that shareholders demand for investing in a company, this return is to serve as a compensation for the risk they undertake while investing. The cost of equity is also market’s demand for compensation from a company in exchange for the ownership of assets and bearing ownership risk.

Cost of equity describes the rate of return paid to investors in exchange for the investments and risk of investing. Dividend capitalization model is the traditional formula for calculating cost of equity (COE), the formula is;

Calculating the Cost of Equity

Calculating the Cost of Equity (COE) is often a difficult task because the rate of return that investors or shareholders require is not explicitly stated. The share capital is also less clearly defined but this does not hold that COE cannot be calculated.

Also, the equity holder which is the market demand certain return on investments. The inability of a firm to meet the expected return can cause the company’s stocks to crash.

As against the traditional formula for calculating COE, the Capital Asset Pricing Model (CAPM) is the commonly acceptable formula. The formula is;

Re = rf + (rm – rf) * β.

Re (required rate of return on equity)

rf  (risk free rate)

rm – rf  (market risk premium)

β (beta coefficient = unsystematic risk).

More comprehensively, Rf (risk-free rate) in the CAPM formula for calculating COE refers to the rate of return obtained from investment which is totally free from credit risk. Investments that have risk-free rates include government bonds and treasury bills.

ß (Beta) refers to the reaction of a share price against the market. A beta value of one does that the reaction of the shares price is in agreement with the general market, beta value more than one indicates that the share price is higher while a beta value less than one indicates stability in the share’s price.

(Rm – Rf) means Equity Market Risk Premium (EMRP), it indicates the difference between risk-free rate and market rate. This is the rate of returns that shareholders or investors expect for taking extra risk by investing more stock in the market.

Cost of Newly Issued Stock

Cost of Newly Issued stock (Rc) is the cost of new equity, that is, cost of external equity. Rc takes the flotation cost (cost incurred by the issuing company) of the new issue into account. Flotation costs have the tendency of increasing the cost of the newly issued stock in a way that it will be more than that of existing equity. Cost of Newly Issued stock can be calculated using the formula below;

Rc = D1__ + g

P0 (1-F)

where:

F = the percentage flotation cost, or (current stock price – funds going to company) / current stock price

 

If a firm’s stock sells at $40, it has an expected return on equity of 10%, if the succeeding year holds a dividend of $2, 30% of the earning is expected to be remitted. Upon issuing an external equity with flotation cost of 5%, the cost of the newly issued stock is calculated as;

Rc = 2 + 0.07 = 0.123, or 12.3%

40(1-0.05)

Here, the cost of the new stock is more than the cost of existing equity.

Weighted Average Cost of Equity

Weighted Average Cost of Equity (WACE) attributes different weight to different equities, it is a more accurate calculation of the total cost of equity a company has. An accurate cost of equity helps to accurately measure a firm’s cost of capital.

To calculate WACE, the cost of new common stock (i.e 24%) must be calculated first, then the cost of preferred stock (10%) and retained earnings (20%).

To calculate further, the total equity occupied by each of the above forms will be calculated, let’s say the have; 50%, 25% and 25% respectively. These figures, portion of total equity are then multiplied by the cost of each from of equity to arrive at WACE.

Hence,

WACE = (24%×50%) (10%×25%) (29%×25%) = 19.5%

Reference for COE (cost of equity)

Research article for “COE (Cost of equity)”

Disclosure level and the cost of equity capital, Botosan, C. A. (1997). Accounting review, 323-349.

A re‐examination of disclosure level and the expected cost of equity capital, Botosan, C. A., & Plumlee, M. A. (2002). Journal of accounting research, 40(1), 21-40.

Globalization of equity markets and the cost of capital, Stulz, R. M. (1999). National Bureau of Economic Research.

Legal protection of investors, corporate governance, and the cost of …

Chen, K. C., Chen, Z., & Wei, K. J. (2009). Journal of Corporate Finance, 15(3), 273-289.

Political connections and the cost of equity capital, Boubakri, N., Guedhami, O., Mishra, D., & Saffar, W. (2012). Journal of Corporate Finance, 18(3), 541-559.

The cost of equity in emerging markets: a downside risk approach, Estrada, J. (2000). Taxes, leverage, and the cost of equity capital, Dhaliwal, D., Heitzman, S., & ZHEN LI, O. L. I. V. E. R. (2006). Journal of Accounting Research, 44(4), 691-723.

Labor unions, operating flexibility, and the cost of equity, Chen, H. J., Kacperczyk, M., & Ortiz-Molina, H. (2011). Journal of Financial and Quantitative Analysis, 46(1), 25-58.

The relationship between disclosure quality and cost of equity capital of listed companies in China [J], Ying, Z., & Zhengfei, L. (2006). Economic Research Journal, 2(7), 2-17.

Shareholder rights, financial disclosure and the cost of equity capital, Cheng, C. A., Collins, D., & Huang, H. H. (2006). Review of Quantitative Finance and Accounting, 27(2), 175-204.

 

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