What Factors Influence the Cost of Equity?

Last Updated: 10 Sep 2025

Every company needs funds to grow. Some businesses may rely on their reserves. But most raise money through different sources like equity, preference shares, loans, or debentures. Each source comes with its own cost for the company and returns for investors. This blog explains what factors influence the cost of equity in a company to help in planning finances and making better investment decisions.

What is the Cost of Equity?

The cost of equity is the return a company must give its shareholders. This is because investors take on risk when they buy company stock. Unlike debt, equity does not have a fixed interest payment. But it still comes with a cost.

For companies, the cost of equity acts like a hurdle rate. If a project earns more than this cost, it adds value for shareholders. If it earns less, the project is not worth it.

For investors, the cost of equity is the minimum return they expect. It depends on many factors like market trends, company performance, and the overall economy.

Why is the Cost of Equity Important?

The cost of equity plays a key role in both business and investment decisions. It affects how companies plan projects, raise money, and measure performance. For investors, it is a guide to value stocks and assess risk. Here are the main reasons why it matters.

1. Evaluating Investment Feasibility

Companies use the cost of equity as a benchmark to check if a project is worth taking up. If the expected return is lower than the cost of equity, the project will not create value. For example, a company planning to expand its factory will compare the cash flows from the project with the cost of equity. If the return is not high enough, the project will be rejected. This ensures money is used wisely.

2. Guiding Capital Structure Decisions

A business needs the right balance of debt and equity to operate efficiently. Debt has interest costs, while equity has its own cost. By comparing the two, companies can choose the cheaper option. If debt is cheaper, they may borrow instead of issuing new shares. This reduces the overall cost of capital and makes financing more effective.

3. Benchmarking Performance

The cost of equity is also used as a performance standard. Investors compare a company’s return on equity with its cost of equity. If the return is higher, the company is creating value for shareholders. If it is lower, the company is underperforming. This makes it easier to judge financial success.

4. Aiding Stock Valuation

Investors use the cost of equity to find the fair value of a stock. Future earnings are discounted using this rate to calculate present value. If the result is higher than the stock’s market price, the stock may be undervalued. If it is lower, the stock may be overpriced. This helps investors make better buy or sell decisions.

5. Reflecting Risk Perception

Equity cost also represents the risk level associated with a company’s shares. A higher price is the market’s signal that the stock is riskier. This can be a challenge in terms of fundraising. For instance, companies in developing countries frequently have more expensive equity because of uncertainties on both the political and economic fronts. Investors will need higher returns to compensate for these risks.

Factors Affecting Cost of Equity

The cost of equity can be affected by different factors. Online trading apps can help investors to track these factors and make informed investment decisions. The different factors affecting cost of common equity are discussed below:

• 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 factors like dividend per share, the market value of the share, dividend growth rate, beta, risk-free return, and expected market return. The factors affecting cost of common equity include the capital structure policy, dividend policy, risk, inflation, exchange rate risk, and so on.

The Formula for the 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.

Frequently Asked Questions

Which of the factors does not affect the cost of capital?

Current assets such as cash and cash equivalents do not influence it. Inventory and prepaid liabilities also do not affect the capital structure and cost of capital.

Is CAPM equity cost of capital?

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

What are the factors that affect WACC?

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.