What are the Factors Affecting The Cost Of Equity?

Every organization aims for growth. It can be in terms of revenue, market expansion, team building, and much more. At the core of all of these, companies carry out humongous projects that can include large capital. Many organizations may have such huge funds in their liquid assets.Therefore, they use various methods to raise funds.

Funds can be acquired from numerous sources in the form of retained earnings, equity capital, preference capital, loans, debentures, etc. Except for retained earnings, all the sources of funds incur a cost for the company and return for providers. This article spotlights the cost of equity.

Factors Affecting The Cost of Equity

The cost of equity is the rate of return expected by equity shareholders in exchange for their equity investment. From the firm’s point of view, it is the cost of acquiring equity capital. Changes in one or more of such factors affecting the cost of equity tend to change the cost of equity. The factors that determine the cost of equity include:

  • Dividend per share

    Dividend per share indicates the distribution of profit of the firm as compensation for an equity share held by an investor. Public companies announce dividends via quarter or annual reports or through press releases. Though not all public companies necessarily pay dividends, this is one of the factors affecting the cost of equity of the firm which pays.

    If the dividend per share for the upcoming year increases, keeping the other factors constant, the cost of equity will increase.

  • The current market value of the share

    The price, at which a company’s stock is traded in the market, is one of the factors that determine the cost of equity. Assuming other factors remain constant, the higher the market value, the lower is the cost of equity and vice versa.

  • Dividend growth rate

    The rate at which dividend grows each year impacts the cost of equity. This growth rate can be calculated by taking the average of computing the past dividends. The growth rate for each year, for calculating the cost of equity, can be derived by the below-mentioned formula.

    Dividend growth = (Dt / Dt-1) – 1

    Where,

    Dt = Dividend for year t

    Dt-1 = Dividend for a year previous to t

  • The risk-free rate of return

    The risk-free rate of return is the rate of return on minimum or negligible risk investment. Return on treasury bills is considered for calculating the cost of equity. The higher the risk-free rate of return, the higher will be the cost of equity and vice versa.

  • Beta

    Beta reflects the changes in the price of the stock relative to the changes in the market. One can easily find beta online or it can be calculated using regression. A beta greater than 1 reflects more volatility of stock as compared to the market and vice versa. If beta equals 1, the stock is as volatile as the market. Lower the beta, lower will be the cost of equity and vice versa.

  • Expected market return

    The return the investors expect based on the ideal index performance is amongst the factors affecting the cost of equity. The higher the expected market return, the higher the cost of equity and vice versa.

Cost of Equity vs. Cost of Capital

Cost of equity is the rate of return a company is required to pay to the equity investors. It forms a part of the cost of capital. From the company’s perspective, the cost of equity is more expensive. Since equity investment is risky for investors, they expect more returns for higher risk.

Cost of capital is the rate of cost of the company’s all sources of funds. From an investor’s perspective, it is a minimum rate of return they expect for the capital provided. It comprises the cost of all forms of funds including equity shares, preference shares, and debt capital. It is calculated using the Weighted Average Cost of Capital (WACC) method.

The cost of equity can be affected by the factors like dividend per share, the market value of the share, dividend growth rate, beta, risk-free return, and expected market return. The cost of capital can be affected by capital structure policy, dividend policy, risk, inflation, exchange rate risk, and so on.

The formula of Cost of Equity

The cost of equity can be computed using two different models–one is the Dividend Capitalization Model and another is the Capital Asset Pricing Model.

Dividend Capitalization Model

The dividend capitalization model is used, to calculate the cost of equity, by those firms which pay dividends to their equity shareholders. This model avoids the element of risk of investment in the calculation.

The following formula is used to calculate the cost of equity:

Re = (D1 / P0) + g

Where,

Re = Cost of equity

D1 = Dividend per share, for next year

P0 = Current market value of the share

g = Dividend growth rate

Capital Asset Pricing Model (CAPM)

The firms which do not pay dividends can consider the Capital Asset Pricing Model to compute the cost of equity. This model considers the element of risk of investment. Though, it uses more estimates which reduces its relevance.

The following formula is used to calculate the cost of equity:

E(Ri) = Rf + B [E(Rm)-Rf)

Where,

E(Ri) = Expected return on asset i

Rf = Risk-free rate of return

B = Beta of asset i

E(Rm) = Expected market return.

Conclusion

There are various factors affecting the cost of equity. An investor can consider these factors to determine their returns. Though, actual returns may vary from this theoretical calculation.

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Frequently Asked Questions Expand All

Current assets such as cash, cash equivalents, inventory, prepaid liabilities, etc. do not affect the capital structure and cost of capital.

Capital Asset Pricing Model (CAPM) is a model used to calculate the cost of equity. This model considers the relationship between risk and expected return.

Economic conditions, capital structure, the dividend policy of a firm, income tax rates, investment decisions are amongst some factors that affect the WACC of a firm.