Q:

How is the cost of common equity calculated?

A:

Investopedia calculates the cost of common equity using the traditional model by dividing next year's estimated dividends per share by the market value of common stock and then adding the growth rate of dividends. Using the capital asset pricing model, cost of equity is determined by subtracting the stock's risk-free rate from the market rate, multiplying the result by the stock's beta coefficient and adding the risk-free rate.

Corporations and stockholders both use the traditional model for calculating the cost of common equity. Investors use the capital asset pricing model to calculate the cost of common equity because it allows for adjustment based on the company's potential risk factors, reports Investopedia. The beta coefficient indicates how the company's stock moves in relation to the market as a whole. A lower beta indicates that the stock is more stable, while a higher beta indicates that the value is exaggerating the market's movements.

According to Investopedia, the cost of common equity is the return expected by stockholders for investments made in the company, or purchase of common stocks. Common equity is considered a cost because, in the event the company does not meet the stockholders' expectations of return on investments, the stockholder is able to sell shares. If stockholders begin selling shares, it drives the price of the company's stock down, which costs the company money. Simply put, the cost of equity for a company is the cost of maintaining stock at a level that is attractive to shareholders.

Sources:

  1. investopedia.com

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