There are many different sources of finance that businesses can use to fund their operations. The main types of finance that they may use include equity and debt. However, each type of finance may come with its costs for the business. Usually, equity is more expensive because it is long-term and, therefore, the business must pay continuous payments to the equity holders. On the other hand, debt may be cheaper as compared to equity. Each type of finance also comes with different advantages and disadvantages. Therefore, the business has to decide which source of finance is the best for its needs.
Since there is a cost for every type of finance, it affects several aspects of the decision-making process of a business. Therefore, it must understand and determine the cost related to each source of finance beforehand to understand which finance it should use. Knowing the costs of each type of finance can also help a business determine its efficiency in the use of the specific type of finance. Usually, it must aim to make returns higher than the costs of finance.
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What is Cost of Equity?
Cost of Equity is the cost of all the equity instruments of a company. It usually represents the rate of return that companies payout to their equity holders. The higher the returns they provide to their shareholders, the higher will be their cost of equity. Similarly, it represents the compensation that shareholders and investors demand in exchange for their investment in a particular company. As mentioned above, the cost of equity will usually be higher than the cost of other sources of finance because equity is a long-term source of finance.
What Is it Used for?
The main use for the cost of equity of a company is during its decision-making process. Specifically, when it comes to capital budgeting decisions, the cost of equity is a vital requirement. Companies also need their cost of equity to calculate their Weighted Average Cost of Capital, which is another crucial requirement for capital budgeting. It helps them make decisions regarding different projects and investments.
Companies also use the cost of capital to determine how much the minimum acceptable returns on a project should be, especially for projects that companies finance through equity only. If a company can determine how much it costs to get the finance, it can also determine how much it requires to generate to not only cover the cost but also make a profit on it. When the company uses other sources of finance along with the cost of equity, it must use the Weighted Average Cost of Capital instead of the cost of equity.
How to Calculate Cost of Equity?
When it comes to calculating the cost of equity, there is no cost of equity formula that companies can use. Instead, they can use two commonly used models to calculate their cost of equity. These are the Capital Asset Pricing Model (CAPM) and the Dividend Growth Model.
CAPM Model
The Capital Asset Pricing Model is a model that companies can use to calculate the cost of equity by using the relationship between the systematic risk and expected returns for equity instruments. Systematic risk is the risk that exists for the entire market or market segment rather than a particular company. CAPM considers the risks associated with an equity instrument, which other models neglect. It is a great option for companies that want to calculate the cost of equity of their risky stocks. Apart from companies, investors can also use the model to calculate the cost of equity for a highly risky firm.
Cost of equity using CAPM can be calculated using the following formula.
Cost of Equity = Risk-free rate of return + Beta value of equity instrument x (Average return on the capital market – Risk-free rate of return)
Alternatively, the CAPM formula can be represented as:
Ke = Rf + βi (E(rm)−Rf)
in an efficient market, the cost of equity for a highly risky firm will not differ from the cost of equity of a low-risk firm. However, since efficient markets do not practically exist, they will be different. The systematic risk in the above formula comes in the form of the Beta value. The Beta value represents the systematic risk of an equity instrument of a company.
Dividend Growth Model
The Dividend Growth Model (DGM), also referred to as the Gordon Growth Model, is another model that companies can use to calculate their cost of equity. Companies can use the model to determine the intrinsic value of equity instruments based on future dividends that will grow at a constant rate. It is based on the Dividend Discount Model (DDM). However, instead of considering fixed dividends in the future, unlike the DDM, DGM assumes they will grow at a constant rate. The dividend growth model cannot be used to compute the cost of equity for a firm that does not pay out dividends or has risky equity instruments.
The formula to calculate the cost of equity of a company using the dividend growth model is straightforward. The cost of equity dividend growth model formula is as below.
P = D1 / (r – g)
In the above formula, ‘P’ represents the current price of the equity instrument in consideration. ‘D1‘ represents next year’s dividends for it. ‘r’ shows the cost of equity of the company. Lastly, ‘g’ represents the constant growth rate for the dividend. The above formula does not calculate the cost of equity of an instrument. However, by rearranging the formula, the company can also find the cost of equity, if the market price of the equity instrument is available.
After rearranging, the formula can be represented as follows.
r = D1 / P + g
Example and Calculation
A company, ABC Co., wants to calculate its cost of equity. It has a beta value compared to the market of 1.2. The average return on the capital market is 9%. Furthermore, the risk-free rate of return in the market is 3%. The company does not pay dividends on its stocks. Therefore, ABC Co. must use the CAPM model to calculate its cost of equity. The cost of equity using the CAPM of ABC Co. is as follows.
Ke = Rf + βi (E(rm)−Rf)
Then we can calculate the cost of equtiy as follow:
Ke = 3% + 1.2 (9% – 3%)
Ke = 3% + 1.2 (6%)
Hence, Ke = 10.2%
The stock of another company, XYZ Co., isn’t as risky as ABC Co. Similarly, it also pays dividends on its stocks, unlike ABC Co. Therefore, XYZ Co. can calculate its cost of capital using the Dividend Growth Model. To calculate its cost of equity under the dividend growth model, XYZ Co., needs some information.
It expects its dividends next year to be $0.5 per share. Similarly, it expects dividends to increase at a rate of 6% every year after that. The price of its stock is $4. Therefore, the company can calculate its cost of equity as follows.
r = D1 / P + g
Then, we can calculate cost of equity as below:
r = $0.5 / ($4 + 6%)
r = $0.5 / $4.06
Hence, r = 12.3%
Advantages and Disadvantages of Using CAPM in Calculation of Cost of Equity
There are certain advantages of using CAPM in the calculation of Cost of Equity. First of all, CAPM incorporates the systematic risk of a business in the calculation of the cost of equity, which other models neglect. By doing so, it eliminates the unsystematic risk. It is also a great tool to use for companies that have a risky stock or do not pay dividends. The calculation of the cost of equity using the model is also relatively straightforward once the beta value is known.
However, it may also have some disadvantages. CAPM model uses too many assumptions when calculating the cost of equity, which can cause inaccurate results. One of these assumptions is the ability of a borrower to borrow at a risk-free rate of return. In an efficient market, it is possible. However, practically, it cannot happen. Furthermore, CAPM also depends on variables that constantly change. Therefore, calculations can become outdated.
Advantages and Disadvantages of Using Dividend Growth Model
Using the dividend growth model can also have some advantages. Firstly, the dividend growth model is a great tool for companies that pay dividends to calculate their cost of equity. It also considers growth in dividend for stock. The calculation is relatively straightforward as all information is readily available from the stock market. As compared to CAPM, the dividend growth model is also easier to understand for managers, as it doesn’t require the calculation of complex values such as beta.
The model also has some disadvantages. Firstly, the model assumes a constant dividend growth rate in perpetuity. While some established companies may have it, other smaller companies don’t. Similarly, the model is highly sensitive to inputs. A simple change in the inputs can significantly affect the result. Finally, the model also does not take into account factors that don’t relate to a dividend but may still impact the cost of equity.
Conclusion
The cost of equity of a company represents the required rate of returns by its shareholders. Cost of equity is critical for several reasons such as capital budgeting. To calculate its cost of equity, a company can use two models, the Capital Asset Pricing Model and the Dividend Growth Model. Both of these models calculate the cost of equity using different inputs. Both of them may have advantages and disadvantages for companies.
