finance Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...

, the cost of equity is the return (often expressed as a

rate of return In finance, return is a profit on an investment. It comprises any change in value of the investment, and/or cash flows (or securities, or other investments) which the investor receives from that investment, such as interest payments, coupons, ca ...

) a firm theoretically pays to its equity investors, i.e.,

shareholder A shareholder (in the United States often referred to as stockholder) of a corporation is an individual or legal entity (such as another corporation, a body politic, a trust or partnership) that is registered by the corporation as the legal own ...

s, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken. Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with

interest In finance and economics, interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an amount above repayment of the principal sum (that is, the amount borrowed), at a particular rate. It is distinct ...

and equity investors seek

dividend A dividend is a distribution of profits by a corporation to its shareholders. When a corporation earns a profit or surplus, it is able to pay a portion of the profit as a dividend to shareholders. Any amount not distributed is taken to be re-in ...

s and/or appreciation in the value of their investment (

capital gain Capital gain is an economic concept defined as the profit earned on the sale of an asset which has increased in value over the holding period. An asset may include tangible property, a car, a business, or intangible property such as shares. ...

). From a firm's perspective, they must pay for the capital it obtains from others, which is called its

cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate new ...

. Such costs are separated into a firm's cost of debt and cost of equity and attributed to these two kinds of capital sources. While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. Finance theory and practice offers various models for estimating a particular firm's cost of equity such as the

capital asset pricing model In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio. The model takes into accou ...

, or CAPM. Another method is derived from the

Gordon Model In finance and investing, the dividend discount model (DDM) is a method of valuing the price of a company's stock based on the fact that its stock is worth the sum of all of its future dividend payments, discounted back to their present value. In ...

, which is a

discounted cash flow The discounted cash flow (DCF) analysis is a method in finance of valuing a security, project, company, or asset using the concepts of the time value of money. Discounted cash flow analysis is widely used in investment finance, real estate devel ...

model based on dividend returns and eventual capital return from the sale of the investment. Another simple method is the Bond Yield Plus Risk Premium (BYPRP), where a subjective risk premium is added to the firm's long-term debt interest rate. In addition, the cost of equity can be calculated by (proposed by Gebhardt et.al. (2001) - see Further Reading Section) using the discounted residual income model to estimate the market implied cost-of-capital. The paper shows that a firm’s implied cost-of-capital is a function of its industry membership, B/M ratio, forecasted long-term growth rate, and the dispersion in analyst earnings forecasts. Moreover, a firm's overall cost of capital, which consists of the two types of capital costs, can be estimated using the

weighted average cost of capital The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its security holders to finance its assets. The WACC is commonly referred to as the firm's cost of capital. Importantly, it is dictated by ...

model. According to finance theory, as a firm's

risk In simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environme ...

increases/decreases, its cost of capital increases/decreases. This theory is linked to observation of human behavior and logic: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier investment instead of a safer one. If an investment's risk increases, capital providers demand higher returns or they will place their capital elsewhere. Knowing a firm's cost of capital is needed in order to make better decisions. Managers make

capital budgeting Capital budgeting in corporate finance is the planning process used to determine whether an organization's long term capital investments such as new machinery, replacement of machinery, new plants, new products, and research development project ...

decisions while capital providers make decisions about

lending In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...

and

investment Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort. In finance, the purpose of investing i ...

. Such decisions can be made after quantitative analysis that typically uses a firm's cost of capital as a model input.

See also

Further reading