The cost of equity is the amount of compensation an investor requires to invest in an equity investment. The cost of equity is estimable is several ways, including the capital asset pricing model (CAPM). The formula for calculating the cost of equity using CAPM is the risk-free rate plus beta times the market risk premium. Beta compares the risk of the asset to the market, so it is a risk that, even with diversification, will not go away. As an example, a company has a beta of 0.9, the risk-free rate is 1 per cent and the expected return on the equity investment is 4 per cent.
- Skill level:
Determine the market risk premium. The market risk premium equals the expected return minus the risk-free rate. The risk-free rate of return is usually the United States three-month Treasury bill rate. In our example, 4 per cent minus 1 per cent equals 3 per cent.
Multiply the market risk premium by beta. In our example, 3 per cent times 0.9 equals 0.027.
Add the risk-free rate to the number calculated in Step 2 to determine the cost of equity. In our example, 0.027 plus 0.01 equals a cost of equity of 0.037 or 3.7 per cent.
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