Cost of equity

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In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk.

The cost of equity capital for a particular company is the rate of return on investment that is required by the company's ordinary shareholders. The return consists both of dividend and capital gains, e.g. increases in the share price. The returns are expected future returns, not historical returns, and so the returns on equity can be expressed as the anticipated dividends on the shares every year in perpetuity. The cost of equity is then the cost of capital which will equate the current market price of the share with the discounted value of all future dividends in perpetuity.

The cost of equity reflects the opportunity cost of investment for individual shareholders. It will vary from company to company because of the differences in the business risk and financial or gearing risk of different companies.

The cost of equity is calculated by the following formula:

The formula above calculates the cost of equity based on a firm's current rate of return. If one assumes a perfect market, industry-specific costs of equity reflect the riskiness of particular industries. A high cost of equity would then indicate a higher-risk industry that should command a higher return to compensate for the higher risk.

However, there are also a variety of other ways to estimate the cost of equity. For example, using the CAPM model, the cost of equity is the product of the Market Risk Premium and the equity's beta plus the risk-free interest rate.

See also

• Cost of capital
• Cost of debt
• Return on equity
• Weighted average cost of capital

Further reading

• Fama, Eugene F.; French, Kenneth R. (1997). "Industry costs of equity". Journal of Financial Economics 43 (2): 158–193. doi:10.1016/S0304-405X(96)00896-3. 
• Francis, Jennifer; et al. (2004). "Costs of Equity and Earnings Attributes". The Accounting Review 79 (4): 967–1010. doi:10.2308/accr.2004.79.4.967. 

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