what is the cost of equity 
the cost of equity is the return that a company requires to decide if an investment meets capital return requirements firms often use it as a capital budgeting threshold for the required rate of return a firm s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership the traditional formula for the cost of equity is the dividend capitalization model and the capital asset pricing model capm investopedia nez riazunderstanding the cost of equitythe cost of equity refers to two separate concepts depending on the party involved if you are the investor the cost of equity is the rate of return required on an investment in equity if you are the company the cost of equity determines the required rate of return on a particular project or investment there are two ways that a company can raise capital debt or equity debt is cheaper but the company must pay it back equity does not need to be repaid but it generally costs more than debt capital due to the tax advantages of interest payments since the cost of equity is higher than debt it generally provides a higher rate of return cost of equity formulausing the dividend capitalization model the cost of equity is cost of equity dpscmv grdwhere dps dividends per share for next yearcmv current market value of stockgrd growth rate of dividends begin aligned text cost of equity frac text dps text cmv text grd textbf where text dps text dividends per share for next year text cmv text current market value of stock text grd text growth rate of dividends end aligned cost of equity cmvdps grdwhere dps dividends per share for next yearcmv current market value of stockgrd growth rate of dividends special considerationsthe dividend capitalization model can be used to calculate the cost of equity but it requires that a company pays dividends the calculation is based on future dividends the theory behind the equation is that the company s obligation to pay dividends is the cost of paying shareholders and therefore the cost of equity this is a limited model in its interpretation of costs the capital asset pricing model however can be used on any stock even if the company does not pay dividends that said the theory behind capm is more complicated the theory suggests that the cost of equity is based on the stock s volatility and level of risk compared to the general market capm formulathe formula for the capital asset pricing model is coe rfrr b mrr rfrr where coe cost of equityrfrr risk free rate of returnb betamrr market rate of return begin aligned text coe text rfrr qquad quad text b times text mrr text rfrr textbf where text coe text cost of equity text rfrr text risk free rate of return text b text beta text mrr text market rate of return end aligned coe rfrr b mrr rfrr where coe cost of equityrfrr risk free rate of returnb betamrr market rate of return in this equation the risk free rate is the rate of return paid on risk free investments such as treasuries beta is a measure of risk calculated as a regression on the company s stock price the higher the volatility the higher the beta and relative risk compared to the general market 1the market rate of return is the average market rate in general a company with a high beta that is a company with a high degree of risk will have a higher cost of equity the cost of equity can mean two different things depending on who s using it investors use it as a benchmark for an equity investment while companies use it for projects or related investments cost of equity vs cost of capitalthe cost of capital is the total cost of raising capital taking into account both the cost of equity and the cost of debt a stable well performing company generally will have a lower cost of capital to calculate the cost of capital the cost of equity and the cost of debt must be weighted and then added together the cost of capital is generally calculated using the weighted average cost of capital 