Definition
Cost of equity represents shareholders' required rate of return, reflecting the opportunity cost of investing in a specific stock versus risk-free alternatives. It is typically estimated using the Capital Asset Pricing Model (CAPM), which adds a risk premium based on the stock's beta to the risk-free rate. Cost of equity is always higher than cost of debt due to equity's junior claim.
functions Formula
Ke = Rf + β × (Rm − Rf)
lightbulb Example
Risk-free rate is 4%, market risk premium is 6%, stock beta is 1.2. Cost of equity = 4% + 1.2 × 6% = 11.2%.
verified_user Key Points
- CAPM is the most common estimation method
- Always higher than cost of debt (equity bears more risk)
- Key input for WACC calculation
- Small-cap and illiquidity premiums may be added