What Are The Factors Affecting The Cost Of Equity

You must understand that every organisation strives towards expansion—in the form of financial, product, and geographical growth as well as brand recognition. However, to push for all this growth, companies undertake several large expenditures, which necessitate substantial expenditures. For that, they use a range of methods to raise money. 

Equity capital, retained earnings, preference capital, loans, debentures, and other forms of financing are a handful of the methods through which companies finance those expenses. All sources of funding—beside retained earnings—entail a cost for the business and a return for the suppliers. This article highlights the factors affecting cost of equity. Listed companies in India, can show the function of their organisation over the share price in the stock market. If you own a demat account and do online share trading you must also look out for the performance of a company where you want to invest. 

What Does Cost of Equity Mean?

Cost of equity is essentially the required rate of return decided by the company to satisfy their shareholders for their equity. It can also be defined as the return on investment that shareholders anticipate getting in return for the risk they take on by purchasing the company's stock. The cost of equity is a key idea in corporate finance since it is used to calculate a business' weighted average cost of capital (WACC). The WACC is the mean expense of all the capital that an organisation has raised to finance its operations, including debt and equity. The WACC can be used to determine if investment initiatives are financially feasible or not.

The Capital Asset Pricing Model (CAPM), which considers the expected return on the market along with the company's beta, a measure of the turbulence of the company's stock relative to the general market, is typically used by analysts to determine the cost of equity. The cost of equity can also be calculated using additional techniques like the Earnings Capitalisation Model (ECM) and the Dividend Discount Model (DDM).

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How to Calculate the Cost of Equity?

Cost of Equity = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate)

The rate of return on a risk-free investment, such as government bonds, is known as the risk-free rate. The 10-year government bond yield in India can be used as a stand-in for the risk-free rate.

Beta is a measurement of the stock's volatility compared to the entire market by numerous financial databases, such as Bloomberg; this data is also available on several investment websites .In India, the whole market return can be approximated using the BSE Sensex or Nifty 50 index.

Key Factors Affecting the Cost of Equity:

Now let’s take a look at the at the key factors affecting the cost of equity: 

Market risk: The overall market risk that is determined by the anticipated return of the market, has an impact on the price of equities. The cost of equity rises in tandem with the market's anticipated return.

Company’s beta profile: The cost of equity will also be influenced by how its beta compares to the rest of the market. If the beta is higher the stock may be considered as riskier investments; it implies the company adopts a riskier business plan, or is less stable financially. If investors believe the company to be riskier, they will expect a greater return.

Dividend policy: A company's dividend policy may have an impact on the cost of equity . Investors may be fine with a reduced return on their stock investments if a company has a history of giving out big amounts of dividends or has a policy of doing so. Likewise, a steady growth rate in dividends may also lead to similar expectations. 

Interest rates: Interest rates have an impact on the cost of capital as well. Interest rates have an impact on the cost of capital as well. Generally the cost of capital is higher when interest rates are surging up and lower when interest rates are on a decline.
 

Market liquidity: The cost of equity can also be impacted by the market liquidity of a firm's shares. Investors may seek a lesser return on their investments from firms with highly liquid shares because these companies are frequently viewed as less risky.

Company size: A company's size might have an impact on the cost of equity. When compared to larger, more well-established organisations, smaller businesses may be seen as riskier; therefore they generally have higher costs of equity.

Conclusion

The rate of return that investors anticipate receiving as a reward for the risk they are incurring by investing their money in the stock of a company is known as the cost of equity. Several variables like market risk, the firm's risk profile, dividend policy, interest rates, market liquidity, and company size can have an impact on the cost of equity, and you can track these factors using a demat account app. When choosing financing options and assessing investment projects, it is crucial for businesses to comprehend the factors affecting the cost of equity.