Cost of Equity: What It Is and How to Calculate It (CAPM Explained)

What Is the Cost of Equity?

The cost of equity is the minimum rate of return that equity investors require to invest in a company, given the risk they are taking. Unlike debt, equity does not have an explicit interest rate — but it has an implicit cost. If shareholders could earn 8% in the market for a similar level of risk and the company only returns 5%, they will sell their shares. The cost of equity is what the company must earn on its equity-financed investments to maintain its share price.

The Capital Asset Pricing Model (CAPM)

CAPM is the most widely used method for estimating the cost of equity: Cost of Equity = Rf + Beta x (Rm - Rf), where Rf is the risk-free rate (typically the yield on government bonds), Beta measures the sensitivity of the company's returns to market returns (a beta of 1 means the stock moves with the market; above 1 means more volatile; below 1 means less volatile), and (Rm - Rf) is the equity risk premium — the additional return investors expect for investing in equities over the risk-free asset.

A Worked Example

Risk-free rate = 4.5% (UK gilt yield). Beta = 1.2 (the company is 20% more volatile than the market). Equity risk premium = 5%. Cost of equity = 4.5% + 1.2 x 5% = 4.5% + 6% = 10.5%. This company needs to earn at least 10.5% on equity-financed investments to satisfy its shareholders.

How Cost of Equity Feeds Into WACC

The weighted average cost of capital (WACC) combines the cost of equity and the after-tax cost of debt, weighted by the proportion of equity and debt in the capital structure. WACC = (E/V) x Ke + (D/V) x Kd x (1-T), where E is equity value, D is debt value, V is total firm value, Ke is cost of equity, Kd is cost of debt, and T is the tax rate. WACC is used as the discount rate in DCF valuations. Cost of equity and WACC are core topics in ACCA AFM and CIMA F3.