Part – 10
In our last tutorial, we have understood the WACC. In this article we will learn about the cost of equity
Part 13 – Cost of Equity
Investors in a company’s equity require a rate of return appropriate to the risk they take in holding such equity. This cost reflects the uncertainty of cash flows associated with the stock, primarily the combination of its dividends and capital gains. The cost of equity is, essentially, the discount rate applied to expected equity cash flows which helps an investor determine the price he or she is willing to pay for such cash flows. A higher discount rate (or cost of equity) will result in an issuing company receiving a lower price for its equity capital. Thus, it has less to invest in the assets which generate returns for all capital holders (debt and equity).
The cost of equity varies with the risk of an issue. As with debt, a higher risk will result in a higher cost associated with taking this risk. In general terms, it has been observed over time that the cost of equity is typically higher than the cost of debt. If a company goes bankrupt, equity holders only receive a return after debt holders are paid. This is because debt holders have a prior claim on assets which reduces the residual claim of equity holders. Conversely, if a company performs well, equity holders receive all the benefits of the upside while debt holders receive only their contracted payments. The increased range of possible outcomes for equity holders, especially in companies with high levels of debt, makes equity more risky and therefore an equity investor will demand a greater return than a holder of debt.
The risk of a given equity to an investor is composed of diversifiable and non diversifiable risk. The former is risk which can be avoided by an investor by holding the given equity in a portfolio with other equities. The effect of diversification is that the diversifiable risks of various equities can offset each other. The risk that remains after the rest has been diversified away is non diversifiable or systematic risk.
Systematic risk cannot be avoided by investors. Investors demand a return for such risk because it cannot be avoided through diversification. Thus, investors demand a return for the systematic risk associated with a stock (as measured by its variability compared to the market) over the return demanded on a risk-free investment. Beta measures the correlation between the volatility of a specific stock and the volatility of the overall market. As a measure of a company’s or portfolio’s systematic risk, beta is used as a multiplier to arrive at the premium over the risk-free rate of an equity investment.