Cost of Equity vs. Cost of Capital: An Overview
A company's cost of capital refers to the cost that it must pay in order to raise new capital funds, while its cost of equity measures the returns demanded by investors who are part of the company's ownership structure.
Cost of equity is the percentage return demanded by a company's owners, but the cost of capital includes the rate of return demanded by lenders and owners.
- The cost of capital refers to what a corporation has to pay so that it can raise new money.
- The cost of equity refers to the financial returns investors who invest in the company expect to see.
- The capital asset pricing model (CAPM) and the dividend capitalization model are two ways that the cost of equity is calculated.
- The cost of capital is computed through the weighted average cost of capital (WACC) formula.
- The cost of capital includes both the cost of equity and the cost of debt.
Cost of Capital
Publicly-listed companies can raise capital by borrowing money or selling ownership shares. Debt investors and equity investors require a return on their money, either through interest payments or capital gains/dividends. The cost of capital takes into account both the cost of debt and the cost of equity.
Stable, healthy companies have consistently low costs of capital and equity. Unpredictable companies are riskier, and creditors and equity investors require higher returns on their investments to offset the risk.
For bondholders and other lenders, this higher return is easy to see; the rate of interest charged on debt is higher. It is more difficult to calculate the cost of equity since the required rate of return for stockholders is less clearly defined.
The cost of equity tends to be higher than the cost of debt. This is because equity investors can receive (potentially) higher gains.
Formula and Calculation
The weighted average cost of capital (WACC) is calculated as follows:
WACC=(VE)×Re+(VD)×Rd×(1−Tc)where:E=Market value of the firm’s equityD=Market value of the firm’s debtV=E+DRe=Cost of equityRd=Cost of debtTc=Corporate tax rate
Note that one of the factors in the cost of capital is the cost of equity.
Factors Affecting Cost of Capital
There are several factors that can affect a firm's cost of capital. One is the type of industry it works in: some industries have higher profit margins than others, and those profits will affect how easy it is to raise capital. Market conditions, such as interest rates, will also determine the cost of borrowing money.
Other factors relate to the quality of management, and the strength of the firm's balance sheet. A company with strong management may be able to raise capital at a lower cost than a similar firm with less reputable managers. Likewise, a company that has a high level of debt may have trouble borrowing more money in the future.
Cost of Equity
A company's cost of equity refers to the compensation the financial markets require in order to own the asset and take on the risk of ownership.
One way that companies and investors can estimate the cost of equity is through the capital asset pricing model (CAPM). To calculate the cost of equity using CAPM, multiply the company's beta by the market risk premium and then add that value to the risk-free rate. In theory, this figure approximates the required rate of return based on risk.
A more traditional way of calculating the cost of equity is through the dividend capitalization model, wherein the cost of equity is equal to the dividends per share divided by the current stock price, which is added to the dividend growth rate.
One weakness of the CAPM model is the difficulty of calculating the beta of a certain investment. Because this can be difficult to determine accurately, a proxy beta is often used. This can affect the reliability of the outcome.
Formula and Calculation
Based on the capital asset pricing model, the cost of equity is determined by:
ERi=Rf+Bi (ERm−Rf)where:ERi=Expected returns of the investmentRf=Risk-free rateBi=Beta of the investmentERm−Rf=Market risk premium
Note that this version of the formula does not factor in dividends.
Factors Affecting Cost of Equity
The cost of equity is affected by the prevailing market conditions. For example, in situations where treasuries and other securities offer relatively high returns, the returns from equity must be even higher to compete with the risk-free rate. In addition, both the value of any dividends and the dividend growth rate will factor in to increase the potential value of a company's equity.
Cost of Equity vs. Cost of Capital
As a hypothetical demonstration of the cost of equity, imagine a hypothetical investor considering a purchase of the imaginary firm XYZ. Each share of XYZ is valued at $100, and the shares have a beta of 1.3 in relation to the rest of the market. In addition, the risk-free rate is 3% and the investor expects the market to rise by 8% per year.
Based on the capital asset pricing model, the investor should expect the returns from XYZ equity to be 9.5%:
Now imagine an analyst calculating XYZ's cost of capital. The company has raised $70 million through equity sales, and $30 million through borrowing. The after-tax cost of debt is 7%.
Using the value for the cost of equity, above, the WACC for XYZ is:
It is important to note that the cost of equity applies only to equity (stock) investments, while the cost of capital accounts for both equity and debt investments.
The cost of equity tends to be higher than the cost of debt. This is because equity investors are rewarded more generously than debtholders, and take higher levels of risks. In addition, debt provides a guaranteed level of payments, and debtholders are given priority in the event of bankruptcy.
Cost of Capital vs. Cost of Equity
Measures the cost of a company's equity (stock) capital
Can be determined through the CAPM or dividend capitalization model.
Measures the cost of equity and debts
Can be calculated using the weighted average cost of capital (WACC) model.
What Factors Can Increase the Cost of Equity?
One important variable in the cost of equity formula is beta, representing the volatility of a certain stock in comparison with the wider market. A company with a high beta must reward equity investors more generously than other companies because those investors are assuming a greater degree of risk.
What Is the Opportunity Cost of Capital?
The opportunity cost of capital represents the potential gains from an investment, compared with the expected gains if that money had been invested in the market. For example, a company considering a new factory will consider the opportunity cost of investing its factory funds in a marketable security. The opportunity cost of capital is calculated by the returns of the option that was foregone from the returns of the chosen option.
Why Is Cost of Capital Important?
The cost of capital tells you how much it costs for a given company to raise money, either by selling shares or borrowing. When the cost of capital is high, the company must pay high interest rates to its creditors or high dividends to its stockholders. This can affect the profits and growth of the company in the long run.
The Bottom Line
Cost of equity and cost of capital are two useful metrics for determining how easy it is for a company to raise the funds it needs to expand and do business. The cost of equity refers to the cost of raising money by selling shares, while the cost of capital also includes the cost of borrowing.