Explain the various approaches to calculate cost of equity with help of examples.

Introduction

The cost of equity represents the return that investors expect for investing in a company’s equity. It is a critical component in financial management, particularly in capital budgeting and valuation. Several models are used to estimate the cost of equity, each with its own assumptions and inputs. This article explains the major approaches to calculating the cost of equity along with practical examples.

1. Dividend Discount Model (DDM)

This model is used when a company pays regular dividends. It assumes the stock value is the present value of future dividends.

Formula:
Ke = (D1 / P0) + g
Where:
Ke = Cost of Equity
D1 = Expected dividend next year
P0 = Current market price of the share
g = Growth rate of dividend

Example:
Company X’s share is priced at ₹100, and it is expected to pay ₹5 as dividend next year with a 6% growth rate.
Ke = (5 / 100) + 0.06 = 0.05 + 0.06 = 11%

2. Capital Asset Pricing Model (CAPM)

CAPM is one of the most widely used models that links risk and expected return using the beta coefficient.

Formula:
Ke = Rf + β (Rm – Rf)
Where:
Rf = Risk-free rate
β = Beta (stock volatility relative to market)
Rm = Expected market return

Example:
Rf = 6%, β = 1.2, Rm = 12%
Ke = 6% + 1.2 × (12% – 6%) = 6% + 7.2% = 13.2%

3. Bond Yield Plus Risk Premium Approach

This approach is suitable for companies that do not pay dividends or are difficult to value using CAPM. It adds a risk premium to the company’s debt cost.

Formula:
Ke = Bond yield + Risk premium

Example:
If a company’s bond yield is 8% and the equity risk premium is estimated at 5%, then:
Ke = 8% + 5% = 13%

4. Earnings Capitalization Approach

This approach is based on expected earnings per share and the market value of the share.

Formula:
Ke = E1 / P0
Where:
E1 = Expected earnings per share
P0 = Market price of the share

Example:
Earnings per share = ₹12, Share price = ₹100
Ke = 12 / 100 = 12%

Comparison of Approaches

Conclusion

Choosing the right method for calculating the cost of equity depends on the availability of data and the nature of the firm. Whether using CAPM, DDM, or earnings-based models, an accurate estimation helps companies make better financing and investment decisions. Understanding multiple approaches ensures flexibility and precision in financial analysis.