Overview of Cost of Equity
The cost of equity is a component of the cost of capital of a particular business enterprise. It is an important term in the context of modern day business operations. The cost of equity could be described as the combination of the risk premium and the risk free return rate.
Meaning of Cost of Equity
The term cost of equity has separate applications in various fields and disciplines. In case of finance the cost of equity could be explained as the least possible rate of return that a particular company has to provide its shareholders.
This rate is normally provided as a form of compensation for the following:
Facing risks by investing in their shares
Having to wait for the returns on the investments
The cost of equity incurred by a particular company could be explained as the returns from equities that are expected by the shareholders of that company. The return from equities is comprised of the capital gains as well as the dividend gains. The capital gains normally result from the rise in the prices of shares.
Description of Cost of Equity
The cost of equity could be described as being related to the opportunity cost the individual shareholders have with respect to their investments. In keeping with the separate levels of risks faced by the companies at the levels of business and finance the opportunity cost also varies for each and every shareholder.
Mathematical Representation of Cost of Equity
The cost of equity could be represented through the following numerical presentation:
Cost of Equity = Next Year’s Dividends per Share/Current Market Value of Stock + Growth Rate of Dividends
Implications of Cost of Equity
The cost of equity of a company is calculated by the above equational representation on the basis of present rate of return being provided by the particular company. In case the market is functioning perfectly then the cost of capital that would be calculated would also show the amount of risk involved with it.
In such cases the higher costs of equity point at higher levels of risk. The higher element of risks mean that the companies also provide higher dividends to cover for the amount of risk that is involved in their company.
Last Updated on : 27th June 2013