The Cost of Equity

The cost of equity is a little less singular than the cost of debt. Equity is any funding raised through the selling of stock. Different people have different ways of measuring equity.

Some people prefer to simply utilize the CAPM or some other form of APT, estimating the cost of equity as an amount equivalent to the risk premium on returns paid by the corporation to its investors. In this manner, any returns generated in excess of the risk-free rate will be deemed to be the cost of equity.

This calculation is simple to use, but it also takes into account fluctuations in the value of shares on the secondary market, which really has no cost to the corporation. Some people argue its benefits.

Another slightly different method is to include all dividend payments made by the corporation (because the risk free rate still costs the company money) and then add to that amount the influence of share value dilution on treasury shares at the time of selling treasure shares or at the time of issuing an additional IPO.

This method takes into account all cash outflows and all depreciated book value on the company resulting from the decision to push extra shares of stock into the marketplace. At that point, investors can decide for themselves whether the returns they’re generating are sufficiently above the risk-free rate.

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