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.
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.
Higher Risk and Higher Returns
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.
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 its 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, where 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.