The Cost of Internal Equity Calculator helps businesses estimate the return investors expect from their investment in the company’s stock. This calculation is vital for evaluating financing decisions, understanding shareholder expectations, and determining the optimal capital structure.
It provides a clear picture of the internal cost of equity, enabling companies to make informed decisions about retaining earnings, issuing dividends, or pursuing external financing.
Formula of Cost Of Internal Equity Calculator
There are three primary models for calculating the cost of internal equity:
1. Dividend Discount Model (DDM)
Cost of Internal Equity (DDM) = (Next Year’s Dividend / Current Stock Price) + Dividend Growth Rate
- Next Year’s Dividend = Current Dividend × (1 + Dividend Growth Rate)
- Current Stock Price = Current market price per share.
- Dividend Growth Rate = Expected annual growth rate of dividends.
2. Capital Asset Pricing Model (CAPM)
Cost of Internal Equity (CAPM) = Risk-Free Rate + Beta × (Market Risk Premium)
- Risk-Free Rate = Return on risk-free securities, such as government bonds.
- Beta = Stock’s volatility relative to the market.
- Market Risk Premium = Expected Market Return − Risk-Free Rate.
3. Earnings Retention Method
Cost of Internal Equity = (Earnings per Share / Current Stock Price) + Growth Rate of Retained Earnings
- Earnings per Share (EPS) = Net Income / Number of Outstanding Shares.
- Growth Rate of Retained Earnings = Retention Ratio × Return on Equity (ROE).
- Retention Ratio = (Net Income − Dividends) / Net Income.
Additional Formulas
- Next Year’s Dividend Formula:
Next Year’s Dividend = Current Dividend × (1 + Dividend Growth Rate) - Market Risk Premium Formula:
Market Risk Premium = Expected Market Return − Risk-Free Rate
General Terms and Pre-Calculated Values Table
| Term | Pre-Calculated Value |
|---|---|
| Average Dividend Growth Rate | 2%–5% annually |
| Risk-Free Rate | 2%–3% (based on government bond yields) |
| Market Risk Premium | 5%–8% |
| Average ROE | 10%–15% |
| Typical Retention Ratio | 0.50–0.70 |
This table offers common benchmark values to aid users in estimating components of the cost of internal equity.
Example of Cost Of Internal Equity Calculator
Scenario: A company currently pays an annual dividend of $3 per share. The current stock price is $50, and the dividend is expected to grow at an annual rate of 4%.
Using DDM:
Next Year’s Dividend = $3 × (1 + 0.04) = $3.12
Cost of Internal Equity (DDM) = ($3.12 / $50) + 0.04 = 0.0624 + 0.04 = 10.24%
Scenario for CAPM:
- Risk-Free Rate: 3%
- Beta: 1.2
- Expected Market Return: 9%
Market Risk Premium = 9% − 3% = 6%
Cost of Internal Equity (CAPM) = 3% + 1.2 × 6% = 3% + 7.2% = 10.2%
Thus, the cost of internal equity is approximately 10.2% using both methods.
Most Common FAQs
It helps businesses evaluate whether retaining earnings or seeking external financing is more beneficial for their operations and long-term growth.
The choice depends on available data and the company’s dividend practices. DDM works well for dividend-paying companies, while CAPM is suitable for any publicly traded company.
A higher beta indicates greater stock volatility, leading to a higher cost of internal equity.