What are the Factors Affecting the Cost of Equity
- 31 May 2023
- By: BlinkX Research Team
What are the Factors Affecting the Cost of Equity?
Growth is the goal of all businesses. Income, market expansion, team building, and many other things are possible. At the heart of all of them, companies execute massive initiatives that may involve significant cash.
There may be multiple organizations that have these substantial amounts in their assets that are liquid. Companies thus employ a variety of techniques to raise money.
Retained profits, equity capital, preference capital, loans, debentures, and other forms of capital can all be used to raise money. With the exception of retained earnings, every source of funding results in a cost for the business and a return for the suppliers. In this article, we will learn about the factors affecting the cost of equity.
Table of Content
- What are the Factors Affecting the Cost of Equity?
- Factors Affecting the Cost of Equity
- Cost of Equity vs Cost of Capital
- The Cost of Equity formula
- Conclusion
Factors Affecting the Cost of Equity
The rate of return equity owners anticipate in return for their equity investment is known as the cost of equity. It is the price of obtaining equity capital from the perspective of the company. The cost of equity is likely to fluctuate if one or more of these variables change. The following factors affecting the cost of equity:
Dividend per share
A dividend per share is a measurement of how much company profit is distributed to shareholders in exchange for their ownership of stock. Public firms release press releases, quarterly or yearly reports, or both to announce dividends. Even while not all publicly traded corporations must pay dividends, this is one of the elements that influence the cost of stock of the company that does.
The cost of equity will rise if the dividend per share for the following year rises while holding the other variables constant.
The share's current market value
One of the elements that affect the cost of equity is the market price at which a company's shares are traded. If all other variables stay constant, the cost of equity decreases with increasing share market value and vice versa.
The return on a risk-free investment
The rate of return on an investment with little to no risk is known as the risk-free rate of return. The return on treasury bills is taken into account while figuring up the cost of equity. The cost of equity will increase in proportion to the risk-free rate of return, and vice versa.
Growth Rate of Dividends
The cost of equity is influenced by the annual growth rate of the dividend. By averaging the dividend calculations from previous years, this growth rate may be determined.
The formula shown below may be used to get the growth rate for each year used to determine the cost of equity.
A dividend increase is equal to (Dt/Dt-1) - 1.
Where,
Dividend for year t equals Dt.
Dt-1 = Dividend paid in the year before t
Beta
Beta represents how the stock's price has changed in relation to market movements. Beta is simple to discover online or to calculate using regression. If the beta is larger than 1, the stock will be more volatile than the market, and vice versa. The stock is equally erratic as the market if the beta is equal to 1. The cost of equity will decrease when beta decreases, and vice versa.
Anticipated Market Return
One of the elements influencing the cost of stock is the return that investors anticipate based on the ideal index performance. The cost of equity rises in proportion to predicted market return, and vice versa.
Cost of Equity vs Cost of Capital
The rate of return a business must provide to equity investors is known as the cost of equity. It is included in the cost of capital. The cost of stock is more expensive in the company's eyes. Investors expect better returns for more risk since investing in stock carries risk.
The cost of capital is the average cost of all the company's funding sources. It is a minimal rate of return that an investor anticipates for the money they have contributed.
It includes the cost of all resources, including capital borrowed, equity shares, and preferred shares. The Weighted Average Cost of Capital (WACC) approach is used to calculate it.
A number of variables, including dividend per share, share price, dividend growth rate, beta, risk-free return, and predicted market return, are the factors affecting the cost of equity. The risk of inflation, risk of currency rate fluctuations, and other factors may affect the cost of capital.
The Cost of Equity formula
Two distinct models—the Dividend Capitalization Model and the Capital Asset Pricing Model can be used to calculate the cost of equity.
Companies that provide dividends to their equity shareholders use the dividend capitalization model to determine the cost of equity.
This model does not include the investment risk component in the computation.
The cost of equity is calculated using the formula below:
Re = (D1 / P0) + g
Where,
Re = Equity Cost
D1 is the dividend per share for the upcoming year.
P0 = The share's current market value
g = Rate of dividend growth
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The Capital Asset Pricing Model can be used by businesses that don't pay dividends to estimate the cost of equity.
This model takes into account the investment risk component. However, it employs additional guesses, which limits its practicality.
The cost of equity is calculated using the formula below:
E(Ri) = Rf plus B [E(Rm)-Rf)
Where,
Expected return on asset i = E(Ri)
The risk-free rate of return is Rf.
B = The asset's beta
E(Rm) stands for expected market return.
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Conclusion
The price of stock is influenced by a number of variables. These elements can be taken into account by an investor when calculating returns. However, real returns could differ from this computation. It is crucial to remember that the cost of stock is arbitrary and changes according to investors' opinions and expectations.
Companies must carefully weigh these variables and find a balance between luring in investors and upholding a sustainable cost of equity that is consistent with their financial objectives and risk tolerance.
