Complete Guide To Corporate Finance

AAA

Cost Of Capital - Cost Of Equity

The cost of equity is the return that stockholders require for their investment in a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:



A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. (Learn more about investing in Hate Dealing With Money? Invest Without Stress and Investment Options For Any Income.)

Here's a very simple example: let's say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a combination of dividends and share appreciation you require a $1.00 return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70, which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

A company that earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)



Calculating the Cost of Equity
The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn't mean no cost of equity exists.

Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors. (For further reading on share price, see Top 5 Stocks Back From The Dead and The Highest Priced Stocks In America.)

On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed formulaically below:

Re = rf + (rm – rf) * β

Where:

  • Re = the required rate of return on equity
  • rf = the risk free rate
  • rm – rf = the market risk premium
  • β = beta coefficient = unsystematic risk

But what does this mean?

  • Rf – Risk-free rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.
  • ß – Beta - This measures how much a company's share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share price moves in the opposite direction to the broader market. (Learn more in Beta: Know The Risk.)
    For public companies, you can find database services that publish betas. Few services do a better job of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta estimation service, this site describes the process by which they come up with "fundamental" betas. Bloomberg and Ibbotson are other valuable sources of industry betas.
  • (Rm – Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium (EMRP) represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become more risky.
    The EMRP frequently cited is based on the historical average annual excess return obtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will in most cases be lower than the arithmetic mean. Both methods are popular, but the arithmetic average has gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease a company's risk profile. Such factors include the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment, and they vary from company to company. (Learn more in The Capital Asset Pricing Model: An Overview.)

Cost of Newly Issued Stock
Cost of newly issued stock (Rc) is the cost of external equity, and it is based on the cost of retained earnings increased for flotation costs (cost of issuing common stock). For a constant-growth company, this can be calculated as follows:

Rc = D1__ + g
P0 (1-F)
where:
F = the percentage flotation cost, or (current stock price - funds going to company) / current stock price


Example: Cost of Newly Issued Stock
Assume Newco's stock is selling for $40, its expected ROE is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. Additionally, assume the company has a flotation cost of 5%. What is Newco's cost of new equity?

Answer:
Rc = 2 + 0.07 = 0.123, or 12.3%
40(1-0.05)

It is important to note that the cost of newly issued stock is higher than the company's cost of retained earnings. This is due to the flotation costs. (For more on newly issued stock, see Why Investors Can't Get Enough Of Social Media IPOs and 5 Signs That Social Media Is The Next Bubble.)

Weighted Average Cost of Equity

Weighted average cost of equity (WACE) is a way to calculate the cost of a company's equity that gives different weight to different aspects of the equities. Instead of lumping retained earnings, common stock and preferred stock together, WACE provides a more accurate idea of a company's total cost of equity.

Here is an example of how to calculate WACE:

First, calculate the cost of new common stock, the cost of preferred stock and the cost of retained earnings. Let's assume we have already done this and the cost of common stock, preferred stock and retained earnings are 24%, 10% and 20% respectively.

Now, calculate the portion of total equity that is occupied by each form of equity. Again, let's assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.

Finally, multiply the cost of each form of equity by its respective portion of total equity, and sum of the values to get WACE. Our example results in a WACE of 19.5%.

WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5%

Determining an accurate cost of equity for a firm is integral in order to be able to calculate the firm's cost of capital. In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future project will be profitable or not.

Cost Of Debt And Preferred Stock
Related Articles
  1. Professionals

    Is A Stockbroker Career For You?

    Becoming a stockbroker requires a broad skill set and the willingness to put in long hours. But the rewards can be enormous.
  2. Economics

    Understanding Cost-Volume Profit Analysis

    Business managers use cost-volume profit analysis to gauge the profitability of their company’s products or services.
  3. Fundamental Analysis

    5 Must-Have Metrics For Value Investors

    Focusing on certain fundamental metrics is the best way for value investors to cash in gains. Here are the most important metrics to know.
  4. Fundamental Analysis

    5 Basic Financial Ratios And What They Reveal

    Understanding financial ratios can help investors pick strong stocks and build wealth. Here are five to know.
  5. Investing

    What Investors Need to Know About Returns in 2016

    Last year wasn’t a great one for investors seeking solid returns, so here are three things we believe all investors need to know about returns in 2016.
  6. Investing Basics

    How to Analyze a Company's Inventory

    Discover how to analyze a company's inventory by understanding different types of inventory and doing a quantitative and qualitative assessment of inventory.
  7. Professionals

    A Day In The Life Of A Public Accountant

    Here's an inside look at the workdays of two experienced CPAs, to give you an idea of what it might be like to pursue a career as a public accountant.
  8. Professionals

    A Day in the Life of a Public Accountant

    There’s no typical day in the life of a public accountant, but one accountant’s experience may shed some light on what the career entails.
  9. Economics

    The Basics Of Business Forecasting

    Whether business forecasts pertain to finances, growth, or raw materials, it’s important to remember that a forecast is little more than an informed guess.
  10. Investing Basics

    How to Become A Self-Taught Financial Expert

    Becoming a self-taught financial expert may not be as daunting of a task as it seems.
RELATED TERMS
  1. Tight Monetary Policy

    A course of action undertaken by the Federal Reserve to constrict ...
  2. Laissez Faire

    An economic theory from the 18th century that is strongly opposed ...
  3. Short-Term Debt

    An account shown in the current liabilities portion of a company's ...
  4. Audit

    An unbiased examination and evaluation of the financial statements ...
  5. Sortino Ratio

    A modification of the Sharpe ratio that differentiates harmful ...
  6. Climate Finance

    Climate finance is a finance channel by which developed economies ...
RELATED FAQS
  1. What should I study in school to prepare for a career in corporate finance?

    Depending on which area you want to specialize in, corporate finance can be one of the most competitive fields in business. ... Read Full Answer >>
  2. Why would a company issue preference shares instead of common shares?

    Preference shares, or preferred stock, act as a hybrid between common shares and bond issues. As with any produced good or ... Read Full Answer >>
  3. What is the difference between cost of debt capital and cost of equity?

    In corporate finance, capital – the money a business uses to fund operations – comes from two sources: debt and equity. While ... Read Full Answer >>
  4. What is the difference between gross profit, operating profit and net income?

    The terms profit and income are often used interchangeably in day-to-day life. In corporate finance, however, these terms ... Read Full Answer >>
  5. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  6. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center