The Cost of Common Equity Calculator is a financial tool used to estimate the cost of raising capital through common equity. This metric is critical for businesses and investors to understand the return required by shareholders to justify their investment risk. By calculating the cost of equity, companies can make informed decisions about funding strategies and evaluate the profitability of equity-based financing. This calculator typically employs two primary methods: the Capital Asset Pricing Model (CAPM) and the Dividend Discount Model (DDM). Each method provides insights based on different assumptions, making them versatile for a variety of financial scenarios.
Formula of Cost Of Common Equity Calculator
The cost of common equity is calculated using either CAPM or DDM:
1. Capital Asset Pricing Model (CAPM)
Cost of Equity (CAPM):
Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium
Formula Components:
- Risk-Free Rate: The return on a risk-free investment, such as government treasury bonds.
- Beta: A measure of the stock’s volatility compared to the overall market.
- Market Risk Premium: The difference between the expected market return and the risk-free rate.
Market Risk Premium = Expected Market Return – Risk-Free Rate
2. Dividend Discount Model (DDM)
Cost of Equity (DDM):
Cost of Equity = (Next Year’s Dividend per Share / Current Stock Price) + Dividend Growth Rate
Formula Components:
- Next Year’s Dividend per Share:
Current Dividend per Share × (1 + Dividend Growth Rate) - Current Stock Price: The current market price of the company’s stock.
- Dividend Growth Rate: The expected annual growth rate of dividends.
Additional Variables and Their Formulas
- Expected Market Return:
Expected Market Return = (Total Market Return Over Period / Initial Market Value) × 100 - Dividend Growth Rate:
Dividend Growth Rate = (Recent Dividend – Previous Dividend) / Previous Dividend × 100
General Terms Table
To simplify calculations, here’s a reference table of common values for variables used in the CAPM and DDM models:
| Variable | Typical Value Range | Notes |
|---|---|---|
| Risk-Free Rate (%) | 2–5 | Based on long-term government bonds |
| Beta | 0.5–2 | Higher values indicate more market volatility |
| Market Risk Premium (%) | 5–10 | Varies based on market conditions |
| Dividend Growth Rate (%) | 3–8 | Depends on the company’s growth potential |
| Current Stock Price ($) | Varies widely | Determined by the market |
| Next Year’s Dividend ($) | Depends on dividend policy | Company-specific |
Example of Cost Of Common Equity Calculator
Scenario 1: Using CAPM
A company’s financial data includes:
- Risk-Free Rate: 3%
- Beta: 1.2
- Market Risk Premium: 6%
Calculation:
Cost of Equity = Risk-Free Rate + Beta × Market Risk Premium
Cost of Equity = 3% + 7.2% = 10.2%
Scenario 2: Using DDM
A company has:
- Current Dividend per Share: $2
- Dividend Growth Rate: 5%
- Current Stock Price: $40
Calculation:
- Next Year’s Dividend per Share = Current Dividend × (1 + Dividend Growth Rate)
Next Year’s Dividend = $2 × (1 + 0.05) = $2.10 - Cost of Equity = (Next Year’s Dividend / Current Stock Price) + Dividend Growth Rate
Cost of Equity = 0.0525 + 5% = 10.25%
Most Common FAQs
The cost of common equity is essential for determining the required return for equity investors. It ensures that companies meet shareholder expectations and make informed funding decisions.
The choice depends on the availability of data. CAPM is widely used for its simplicity and market-focused approach, while DDM is best suited for companies with stable dividend policies.
Companies can reduce their cost of equity by lowering business risk, maintaining a strong financial position, and improving investor confidence through transparent governance.