Equity Investment: Understanding The True Cost Of Ownership

The cost of equity is a central variable in financial decision-making for businesses and investors. It is the rate of return a company pays out to equity investors, and it is influenced by the risk of the investment. The cost of equity is part of a company's overall cost of capital and is an input to stock valuation models. It is also an essential indicator of how effectively a business is run and is inversely related to company valuation.

There are two commonly used models for calculating the cost of equity: the capital asset pricing model (CAPM) and the dividend capitalization model. The CAPM is the most widely used formula and is considered more accurate than the dividend capitalization model because it includes consideration of investment risk.

The cost of equity is higher than the cost of debt because the cost associated with borrowing debt financing (i.e. interest expense) is tax-deductible, creating a tax shield. Additionally, debt holders have legal priority over equity holders, making their investments less risky. Equity investors expect a higher return because they bear a higher investment risk.

Cost of equity vs cost of debt

The cost of equity and the cost of debt are two main components of the cost of capital, which is the opportunity cost of making an investment. Companies can acquire capital in the form of equity or debt, or a combination of both.

Cost of Equity

The cost of equity is the return that a company requires for an investment or project, or the return that an individual requires for an equity investment. It is the rate of return expected by shareholders for their investment. It can be calculated using different models, with the Capital Asset Pricing Model (CAPM) being one of the most commonly used. The cost of equity is often higher than the cost of debt. Equity investors are compensated more generously because equity is riskier than debt.

Cost of Debt

The cost of debt is the interest a company pays on its borrowings. It is the rate of return expected by bondholders for their investment. It is usually expressed as an after-tax rate as interest on debt financing is tax-deductible. The cost of debt is generally lower than the cost of equity. Debt is cheaper, but the company must pay it back.

Cost of Capital

The cost of capital is the total cost of raising capital, taking into account both the cost of equity and the cost of debt. It is the minimum return a company must earn on its investments to satisfy its investors and cover its financing costs. It is often used as a threshold for companies when considering strategic maneuvers to raise additional capital from external sources.

Weighted Average Cost of Capital (WACC)

The WACC is the average capital cost, weighted by the proportion of total funding provided by each capital source. It takes into account both the cost of equity and the cost of debt and is used when a company has both debt and equity in its financial structure.

The decision to choose between equity financing and debt financing depends on several factors, including the company's mission, objectives, and preferences for control and risk. Equity financing is generally more expensive but avoids the upfront expense of interest repayment associated with debt financing. Debt financing, on the other hand, may provide established loan terms and faster funding but comes with the risk of personal liability and the obligation to make loan payments immediately.

Cost of equity calculation methods

There are two primary methods for calculating the cost of equity: the dividend capitalization model and the capital asset pricing model (CAPM).

Dividend Capitalization Model

The dividend capitalization model is calculated using the following formula:

> Cost of Equity = DPS/CMV + GRD

Where:

• DPS = Dividends per share for the next year
• CMV = Current market value of stock
• GRD = Growth rate of dividends

This model is relatively simple and easy to calculate. However, it has the downside of requiring that the company pays dividends. Additionally, it is limited in its interpretation of costs as it is based solely on future dividends.

Capital Asset Pricing Model (CAPM)

The capital asset pricing model is calculated using the following formula:

> Cost of Equity = Risk-Free Rate of Return + Beta x (Market Rate of Return – Risk-Free Rate of Return)

Or:

> CoE = RFRR + B x (MRR – RFRR)

Where:

• CoE = Cost of Equity
• RFRR = Risk-free rate of return
• B = Beta
• MRR = Market rate of return

CAPM takes into account the riskiness of an investment relative to the market. However, it is less exact due to the estimates made in the calculation, as it relies on historical information.

Other Methods

Some sources also mention two other methods for calculating the cost of equity:

• Weighted Average Cost of Equity (WACE): This method is used by companies with multiple forms of equity and considers stock prices, retained earnings, and equity distribution.
• Equity Risk Premium (ERP): This is the incremental risk of investing in equities rather than risk-free securities like bonds. It is calculated as Expected Market Return – Risk-Free Rate.

Cost of equity and capital structure

The cost of equity is the return that a company requires to decide if an investment meets capital return requirements. It is used as a capital budgeting threshold for the required rate of return. 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.

There are two ways to calculate the cost of equity: the dividend capitalization model and the capital asset pricing model (CAPM). The dividend capitalization model is based on the dividends per share (DPS) for the next year, the current market value (CMV) of the stock, and the growth rate of dividends (GRD). The formula is: Cost of Equity = DPS/CMV + GRD. The CAPM, on the other hand, evaluates if an investment is fairly valued, given its risk and time value of money in relation to its anticipated return. The formula for CAPM is: Cost of Equity = Risk-Free Rate of Return + Beta x (Market Rate of Return – Risk-Free Rate of Return).

The cost of equity is an important factor in a company's capital structure, which refers to the amount of debt and/or equity employed to fund its operations and finance its assets. A firm's capital structure is typically expressed as a debt-to-equity or debt-to-capital ratio. The optimal capital structure is often considered to be the proportion of debt and equity that results in the lowest weighted average cost of capital (WACC).

The cost of equity is higher than the cost of debt because equity investors are compensated more generously than debt holders, as they take on higher levels of risk. Equity investors also have a higher expected rate of return than debt holders. Therefore, companies that issue equity will have a higher cost of capital compared to companies that issue debt.

When considering their capital structure, companies must balance the benefits of issuing equity, such as no interest payments and ownership control, with the higher cost of equity capital. By optimizing their capital structure, companies can maximize their value or minimize their WACC.

Cost of equity and company valuation

The cost of equity is the rate of return a company requires to decide if an investment meets its capital return requirements. It is the return that a company requires for an investment or project, or the return that an individual requires for an equity investment. The cost of equity is used as a benchmark for an equity investment by investors, while companies use it for projects or related investments.

There are two ways to raise capital: debt or equity. Debt is cheaper but must be paid back, while equity does not need to be repaid and thus generally costs more. The cost of equity is calculated using either the dividend capitalization model or the capital asset pricing model (CAPM).

The dividend capitalization model is based on future dividends and is calculated as:

> Cost of Equity = DPS/CMV + GRD

Where DPS = Dividends per share for the next year, CMV = Current market value of stock, and GRD = Growth rate of dividends.

The CAPM, on the other hand, can be used on any stock and is based on the stock's volatility and level of risk compared to the general market. The formula for the CAPM is:

> CoE = RFRR + B x (MRR - RFRR)

Where CoE = Cost of Equity, RFRR = Risk-free rate of return, B = Beta, and MRR = Market rate of return.

The cost of equity is an important consideration for companies when determining how to raise capital. It is often compared to the cost of debt when making capital structure decisions. A company with a high beta, indicating higher risk, will generally have a higher cost of equity.

When it comes to company valuation, the cost of equity plays a crucial role in determining the expected rate of return for investors. A high cost of equity indicates that shareholders require a greater return due to perceived higher risks. This information can help investors make more informed decisions and guide critical financial choices.

In summary, the cost of equity is a key metric in investment decisions, helping investors and companies assess the potential returns and risks of different opportunities. By understanding the cost of equity, businesses can make better-informed choices to protect their financial health and ensure their investments pay off.

Cost of equity and hurdle rate

The cost of equity is the rate of return a company pays out to equity investors. Companies use the cost of equity to assess the relative attractiveness of investments, including both internal projects and external acquisition opportunities.

There are two primary ways to calculate the cost of equity: the dividend capitalization model and the capital asset pricing model (CAPM). The dividend capitalization model takes dividends per share (DPS) for the next year divided by the current market value (CMV) of the stock, and adds this number to the growth rate of dividends (GRD). The formula is:

> Cost of Equity = DPS/CMV + GRD

The capital asset pricing model evaluates if an investment is fairly valued, given its risk and time value of money in relation to its anticipated return. The formula is:

> Cost of Equity = Risk-Free Rate of Return + Beta x (Market Rate of Return – Risk-Free Rate of Return)

The hurdle rate is the minimum rate of return a project or investment must achieve before a manager or investor deems it acceptable. It is important when companies or investors make important decisions like pursuing a specific project. Riskier projects generally have higher hurdle rates than those with less risk. The hurdle rate is calculated using the formula:

> Hurdle Rate = WACC + Risk Premium

The WACC, or weighted average cost of capital, is the combined costs of debt and equity financing, weighted by their respective proportions in the company's capital structure. The risk premium accounts for the level of risk associated with the investment, with higher-risk projects typically demanding higher risk premiums.

Frequently asked questions