Cost Of Capital - Cost Of Equity

The cost of equity is the return that stockholders require for their investment in a company. The
traditional formula for cost of equity (COE) is the dividend capitalization model:

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. (Learn more about investing in Hate Dealing With Money? Invest Without Stress and
Investment Options For Any Income.)
Here's a very simple example: let's say you require a rate of return of 10% on an investment in
TSJ Sports. The stock is currently trading at $10 and will pay a dividend of $0.30. Through a
combination of dividends and share appreciation you require a $1.00 return on your $10.00
investment. Therefore the stock will have to appreciate by $0.70, which, combined with the
$0.30 from dividends, gives you your 10% cost of equity.
A company that earns a return on equity in excess of its cost of equity capital has added value.
Calculating the Cost of Equity
The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost.
Unlike debt, which the company must pay in the form of predetermined interest, equity does not
have a concrete price that the company must pay, but that doesn't mean no cost of equity exists.
Common shareholders expect to obtain a certain return on their equity investment in a company.
The equity holders' required rate of return is a cost from the company's perspective because if the
company does not deliver this expected return, shareholders will simply sell their shares, causing
the price to drop. The cost of equity is basically what it costs the company to maintain a share
price that is theoretically satisfactory to investors. (For further reading on share price, see Top 5
Stocks Back From The Dead and The Highest Priced Stocks In America.)
On this basis, the most commonly accepted method for calculating cost of equity comes from the
Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed
formulaically below:
Re = rf + (rm rf) *
Where:

Re = the required rate of return on equity

rf = the risk free rate

rm rf = the market risk premium

= beta coefficient = unsystematic risk

But what does this mean?

Rf Risk-free rate - This is the amount obtained from investing in securities considered
free from credit risk, such as government bonds from developed countries. The interest
rate of U.S. Treasury Bills is frequently used as a proxy for the risk-free rate.

Beta - This measures how much a company's share price reacts against the market as
a whole. A beta of one, for instance, indicates that the company moves in line with the
market. If the beta is in excess of one, the share is exaggerating the market's movements;
less than one means the share is more stable. Occasionally, a company may have a
negative beta (e.g. a gold-mining company), which means the share price moves in the
opposite direction to the broader market. (Learn more in Beta: Know The Risk.)
For public companies, you can find database services that publish betas. Few services do
a better job of estimating betas than BARRA. While you might not be able to afford to
subscribe to the beta estimation service, this site describes the process by which they
come up with "fundamental" betas. Bloomberg and Ibbotson are other valuable sources of
industry betas.

(Rm Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium
(EMRP) represents the returns investors expect to compensate them for taking extra risk
by investing in the stock market over and above the risk-free rate. In other words, it is the
difference between the risk-free rate and the market rate. It is a highly contentious figure.
Many commentators argue that it has gone up due to the notion that holding shares has
become more risky.
The EMRP frequently cited is based on the historical average annual excess return
obtained from investing in the stock market above the risk-free rate. The average may
either be calculated using an arithmetic mean or a geometric mean. The geometric mean
provides an annually compounded rate of excess return and will in most cases be lower
than the arithmetic mean. Both methods are popular, but the arithmetic average has
gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors
specific to the company, which may increase or decrease a company's risk profile. Such factors
include the size of the company, pending lawsuits, concentration of customer base and
dependence on key employees. Adjustments are entirely a matter of investor judgment, and they
vary from company to company.

Cost Of Capital - Cost Of Debt And Preferred Stock

Recall from Section 5 that companies sometimes finance their operations through debt in the
form of bonds because bonds provide more flexible borrowing terms than banks. How much do
companies pay for this debt?
Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate applied to
determine the cost of debt (Rd) should be the current market rate the company is paying on its
debt. If the company is not paying market rates, an appropriate market rate payable by the
company should be estimated.
Calculating the Cost of Debt
Because companies benefit from the tax deductions available on interest paid, the net cost of the
debt is actually the interest paid less the tax savings resulting from the tax-deductible interest
payment.
The after-tax cost of debt can be calculated as follows:

After-tax cost of debt = Rd (1-tc)

Note: Rd represents the cost to issue new
debt, not the cost of the firm\'s existing debt.
Example: Cost of Debt
Newco plans to issue debt at a 7% interest rate. Newco's total (both federal and state) tax rate is
40%. What is Newco's cost of debt?
Answer:
Rd (1-tc) = 7% (1-0.40) = 4.2%
Calculating the Cost of Preferred Stock
As we discussed in section 6 of this walkthrough, preferred stocks straddle the line between
stocks and bonds. Technically, they are equity securities, but they share many characteristics with
debt instruments. Preferreds are issued with a fixed par value and pay dividends based on a
percentage of that par at a fixed rate.
Cost of preferred stock (Rps) can be calculated as follows:

Rps = Dps/Pnet
where:
Dps = preferred
dividends
Pnet = net issuing price

Example: Cost of Preferred Stock

Assume Newco's preferred stock pays a dividend of $2 per share and sells for $100 per share. If
the cost to Newco to issue new shares is 4%, what is Newco's cost of preferred stock?
Answer:
Rps = Dps/Pnet = $2/$100(1-0.04) = 2.1%
For more on this subject, read Prefer Dividends? Why Not Look At Preferred Stock?
Next, we'll take a look at the weighted average cost of capital, a calculation that will put our
formulas for both the cost of equity and the cost of debt to work.
Cost of Capital - Introduction To Cost Of Capital
Cost of capital is the required return necessary to make a capital budgeting project, such as
building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of
equity. A company uses debt, common equity and preferred equity to fund new projects, typically
in large sums. In the long run, companies typically adhere to target weights for each of the
sources of funding. When a capital budgeting decision is being made, it is important to keep in
mind how the capital structure may be affected.
Capital structure is a mix of a company's long-term debt, specific short-term debt, common
equity and preferred equity. The capital structure represents how a firm finances its overall
operations and growth by using different sources of funds.
Debt comes in the form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Short-term debt such as working capital
requirements is also considered to be part of the capital structure.
A company's proportion of short and long-term debt is considered when analyzing capital
structure. When people refer to capital structure they are most likely referring to a firm's debt-toequity ratio, which provides insight into how risky a company is. Usually a company more
heavily financed by debt poses greater risk, as this firm is relatively highly levered.
Optimal capital structure is the best debt-to-equity ratio for a firm that maximizes its value and
minimizes the firm's cost of capital. In theory, debt financing generally offers the lowest cost of

capital due to its tax deductibility. However, it is rarely the optimal structure since a company's
risk generally increases as debt increases. A healthy proportion of equity capital, as opposed to
debt capital, in a company's capital structure is an indication of financial fitness.