The Cost of Equity is the return required by investors to compensate for the risk of investing in a company’s equity. It’s what shareholders expect in return for funding your business—without considering debt.
| Field | Description |
|---|---|
| Risk-Free Rate (%) | Usually based on government bond yield (e.g., U.S. 10-year treasury yield). |
| Beta (β) | Measures the stock’s volatility compared to the market. A beta of 1 = same volatility. |
| Expected Market Return (%) | Average return of the overall stock market (e.g., 8–12%). |
| Benefit | Description |
|---|---|
| Investment Appraisal | Helps assess the viability of a business or project. |
| Capital Budgeting | Used in determining hurdle rates and discounting future cash flows. |
| Risk Analysis | Reflects how much investors need to be compensated for the risk they take. |
| Valuation Models | Important in Dividend Discount Model (DDM), WACC, and other corporate finance formulas. |
If you entered:
Risk-Free Rate = 89%
Beta = 0.3
Market Return = 12%
Then CAPM gives:
\text{Cost of Equity} = 89 + 0.3 \times (12 – 89) = 89 + 0.3 \times (-77) = 89 – 23.1 = \textbf{65.9%}
That’s still positive—but if the math produces a negative value, it’s likely due to:
Beta near zero or negative
Market return lower than risk-free rate
Data entry error (e.g., percent not properly formatted)
CAPM is especially useful when:
Evaluating publicly traded companies
Building a Discounted Cash Flow (DCF) model
Performing equity valuation
Assessing the hurdle rate for investment projects
Calculating WACC (Weighted Average Cost of Capital)
| Model | Description | Use Case |
|---|---|---|
| CAPM | Risk-free rate + beta × market premium | Market-based analysis; easy to apply |
| Dividend Discount Model (DDM) | (Dividends / Share Price) + Growth Rate | Dividend-paying stocks |
| Build-Up Method | Risk-free rate + risk premiums | Private companies & startups (no beta) |
| Input | Where to Get It |
|---|---|
| Risk-Free Rate | U.S. Treasury Yield (e.g., 10-year) from Treasury.gov |
| Beta | Yahoo Finance, Morningstar, or analyst reports |
| Market Return | Estimated from historical S&P 500 returns (~7–10%) or forward-looking market reports |
It’s the return on an investment with zero risk, typically the yield of government bonds like the U.S. 10-year Treasury note.
Beta measures how much a company’s stock fluctuates compared to the market.
β = 1: Same as the market
β > 1: More volatile
β < 1: Less volatile
Expected market return usually ranges from 7–12%, based on long-term historical returns of the stock market (like the S&P 500).
Technically yes, if inputs are unrealistic (e.g., beta near zero, market return less than risk-free rate). In reality, negative cost of equity implies flawed assumptions.
Because it provides a simple, market-based method to estimate returns and assess investment risk. It’s widely used in valuation and financial modeling.
Check finance sites like Yahoo Finance, Google Finance, or analyst reports. For private companies, use industry comparables.
There’s no universal “good” rate—it depends on the company’s risk profile. Stable firms may have 6–10%, while riskier firms can go above 15%.
The formula may produce a negative result. This typically reflects unrealistic or outdated input assumptions.
A negative result typically suggests unrealistic inputs. For instance, if the market return is less than the risk-free rate, or if beta is incorrectly estimated, the calculation might result in negative returns, which doesn't reflect real-world market behavior.
A higher cost of equity means that investors demand more return for taking on higher risk. If a company’s beta is high, this might indicate higher growth potential, but it also signals increased volatility and risk, which investors must be compensated for.
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