What is Cost of Equity? Types

What is Cost of Equity?

When we talk about the term cost of capital, it is usually quite vague as capital could be raised from various types of sources such as equity, debt or preference shares. Therefore, the cost of capital is usually categorised into four types, which are as follows:

• Cost of equity
• Cost of debt
• Cost of preference shares
• Cost of retained earnings

The cost of equity capital refers to the cost of using the capital of equity shareholders in the business. The business pays its cost in two major forms namely dividends and capital appreciation, i.e., increase in share price. In other words, the rate of return a corporation pays to shareholders is known as the cost of equity.

The cost of equity is used by a company to evaluate the relative profitability of various investments, including both internal and external purchase options. The cost of equity can be determined using various methods such as dividend price approach, price approach, growth approach, realised yield approach and the Capital Asset Pricing Model (CAPM) approach which are discussed in the upcoming sections.

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Dividend Price Approach

Before investing in equity stocks, investors consider the dividend price approach. Even before acquiring equity shares, shareholders have certain reasonable dividend requirements. An investor must determine the current market price of equity shares as well as the current dividend rate.

The cost of equity can be determined using the dividend price approach using the formula:

K_e = Dividend Per Share×100 Dividend per share = × 100
Market Price Per Share

The dividend price approach is criticised for the following reasons:

• This approach does not account for the increase in the value of capital. The dividend price approach assumes that investors anticipate receiving a dividend on their stock. It neglects the fact that some investors take into account the possibility of capital appreciation, which enhances the value of their stock.
  
  
• This approach dismisses the impact of retained earnings, which have an impact on both the market price of shares and the dividend amount paid. For example, if a company holds a large amount of its profit as retained earnings, it would likely pay a low dividend, lowering the market price of its stock.

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Price Approach

According to the profitability price ratio approach, the cost of equity capital is determined by an organisation’s fixed revenues. An investor expects a business to make a specific level of profit. Shareholders do not always anticipate the company to pay out dividends on a consistent basis. They might prefer that the organisation reinvest the dividend money into new projects to make a profit. As a result, the company’s earnings will rise, raising the value of its stock on the market.

The cost of capital can be determined using the earnings price ratio approach as follows:

The price approach is criticised for the following reasons:

• This approach implies that EPS will not change.
  
  
• This approach assumes that the market price per share will not change.
  
  
• This approach neglects the fact that an organisation’s earnings are not entirely dispersed in the form of a dividend.

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Growth Approach

The dividend price plus growth approach refers to a strategy in which the dividend rate increases over time. At times, the shareholders anticipate dividend in addition to a consistent dividend growth. Thedividend growth rate is expected to be the same as the EPS and market price per share growth rates.

The cost of capital using the dividend price plus growth method is calculated as follows:

K_e = D MP + g

Where,

D = Expected dividend per share at the end of period

MP = Present market price

g = Growth rate in expected dividends

Dividend price plus growth approach is believed to be the most effective for assessing shareholder expectations and calculating the cost of equity capital.

Example: A company’s stock is currently trading at ₹20 in the market. The company pays ₹1 per share dividend, and the stock market predicts a 5% annual growth rate.

• Determine the equity cost of capital for the company.
  
  
• Calculate the recommended market price per share if the expected growth rate is 6% per year.
  
  
• Calculate the stated market price if the dividend of ` 1 per share is to be kept if the company’s cost of capital is 8% and the expected growth rate is 5% p.a.

Solution:

The equity cost of capital is as follows:

• K_e D MP + g = [(1/20) + 0.05] = 0.05 + 0.05 = 0.10 = 10%
  
  
• 0.10 = [(1/MP) + 0.06] = (1/MP) = 0.04
  
  MP = 1/0.04 = 100/4 = 25
  
  
• 0.08 = [(1/MP) + 0.05]
  
  (1/MP) = 0.03
  
  MP = 1/0.03
  
  = 100/3
  
  = 33.3

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Realised Yield Approach

With the realised yield approach, an investor aims to earn the same amount of dividend as the company has paid in the previous few years. The rate of dividend growth is not a critical factor in determining the cost of capital in this approach.

The following assumptions underpin this strategy:

• In an organisation, the risk factor remains constant. Revenues in the given risk remain consistent with shareholder expectations.
  
  
• The reinvestment opportunity value for shareholders is equal to the realised yield.

The cost of capital can be determined numerically using the realised yield technique by applying the following formula:

K_e = [{(D – P)/p} – 1] × 100

Where,

P = Price at the end of the period,

p = Price per share to day

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Capital Asset Pricing Model (CAPM) Approach

In the capital market, the CAPM aids in determining the expected rate of return from a share of similar risk. The cost of risky shares would be the same as the cost of missed opportunities. An investor, for example, has the option of purchasing shares in either X Ltd. or Y Ltd. If the investor chooses to purchase X Ltd. shares, the cost of Y Ltd. shares will be the cost of a missed opportunity.

The CAPM is founded on the following assumptions:

• A rational investor would avoid risk at all costs.
  
  
• A reasonable investor always wants to maximise the expected return.
  
  
• Everyone’s expectations would be the same.
  
  
• All investors are free to lend at risk-free rates of return.
  
  
• The capital market is in good shape, and there are no taxes.
  
  
• The capital market is inherently competitive.
  
  
• Securities are fully divisible and incur no transaction costs.

The cost of capital is calculated using CAPM under the assumption that the required rate of return on any share is equivalent to the sum of risk less rate of interest and risk premium.

According to CAPM, the cost of equity is calculated as:

Ke = R_f + β (E(R_m) – R_f )

Where,

K_e = Cost of Equity

R_f = Risk free rate

β = Beta of stock/company

E (R_m) – R_f = Equity Risk premium

Concept of Beta

An investment security’s beta is a reflection of its return volatility in comparison to the total market. Beta is a component of the Capital Asset Pricing Model (CAPM) and is used as a risk metric. A corporation with a higher beta is riskier, but it also has a larger predicted yield.

The beta coefficient is interpreted as below:

β =1; Stock is exactly as volatile as the market

β >1; Stock is more volatile than the market

β <1 but >0; Stock is less volatile than the market

β = 0; Stock is uncorrelated to the market

β <0; Stock is negatively correlated to the market

Different Types of Beta

• High Beta: A business with a beta larger than 1 is more volatile than the market. A high-risk technological business with a beta of 1.75, would have returned 175% of the market in a given period.
  
  
• Low Beta: A firm with a beta lower than one is less volatile than the market. Consider an electric utility firm with a beta of 0.45, which would have returned only 45% of the market over a given period.
  
  
• Negative Beta: A firm with a negative beta is inversely related to the market’s returns. For example, a gold business with a – 0.2 beta would have returned – 2% if the market had increased by 10%.