Question

What is the meaning of cost of equity? Who pays this cost of equity and to whom? How do you calculate the cost of equity?

Answer 1

Cost of equity refers to the cost incurred by the firm in raising the equity.A firm's cost of equity is often an indicator of how much the market requires as a compensation for investing in the company and bearing the risk of being an owner.It's paid by the firm to it's investors.The cost of equity is used by the firm to evaluate project proposals and determine their profitability.

Capital Asset Pricing Model(CAPM) is a method used to determine a firm's cost of equity.The method determines the the cost of equity of the firm by taking into consideration the volatility associate with the firm's stock and level of risk in relation to the market.Cost of equity according to CAPM model=Risk free rate +Beta*(market rate -Risk free rate). Risk free rate refers to the rate of return offered by risk free securities like Treasury bills.Beta is estimate of the stock's volatility in relation to the overall market.(Market rate -risk free) rate gives risk premium.Market rate is the average market rate .

Another model used for cost of equity assessment is dividend discount model.According to dividend discount model the cost of equity =(Dividend Per share/Current Market Value of share)+Growth rate of dividends.the drawback of this method is that it can only be used if company pays dividends.Else CAPM is used.