###### Describe Corporate Governance

Corporate governance may be defined as the system of internal controls, processes, and... **Read More**

A company can increase its common equity either by reinvesting its earnings or issuing new stock. The cost of equity will, therefore, be the rate of return that is required by its shareholders.

Three methods are used to estimate the cost of equity. These are the capital asset pricing model, the dividend discount model, and the bond yield plus risk premium method.

The application of the Capital Asset Pricing Model (CAPM) to compute the cost of equity is based on the following relationship:

$$ E\left( { R }_{ i } \right) ={ R }_{ F }+{ \beta }_{ i }\left[ E\left( { R }_{ M } \right) -{ R }_{ F } \right] $$

Where:

*E(R _{i})* = the cost of equity or the expected return on a stock

*R _{f}* = the risk-free rate of interest

*B _{i}* = the equity beta or return sensitivity of stock

*E(R _{m})* = the expected market return

Note that the expression *E(R _{m}) – R_{f}* is known as the expected market risk premium or equity risk premium.

The risk-free rate of interest may be estimated by the yield on a default-free government debt instrument.

A company’s equity beta is estimated to be 1.2. If the market is expected to return 8% and the risk-free rate of return is 4%, what is the company’s cost of equity?

**Solution**

The company’s cost of equity = 4% + 1.2(8% – 4%) = 4% + 4.8% = 8.8%

According to the dividend discount model, the intrinsic value of a share of stock is the present value of the share’s expected future dividends. Based on Gordon’s constant growth model, dividends are expected to grow at a constant rate, *g*. Therefore, assuming that the share price reflects the intrinsic value, the value of a stock is:

$$ { P }_{ 0 }=\frac { { D }_{ 1 } }{ { r }_{ e }-g } $$

Where:

*P _{0}* = the current share price

*D _{1}* = the dividend to be paid in the next period

*r _{e}* = the cost of equity

Rearranging the equation,

$$ { r }_{ e }=\frac { { D }_{ 1 } }{ { P }_{ 0 } } +g $$

Where:

$$ \frac { { D }_{ 1 } }{ { P }_{ 0 } } $$

is known as the forward annual dividend yield.

*g* may also be referred to as the sustainable growth rate and can be estimated by the following relationship:

$$ g=\left( 1-\frac { D }{ EPS } \right) \left( ROE \right) $$

Where ROE is the return on equity, and

$$ \frac { D }{ EPS } $$

is the assumed stable dividend ratio, which makes

$$ \left( 1-\frac { D }{ EPS } \right) $$

the earnings retention ratio.

If a company’s sustainable growth rate is 8.24% and its forward annual dividend yield is 4.16%, what is the estimate of its cost of equity?

**Solution**

The company’s cost of equity = 4.16% + 8.24% = 12.40%

According to the bond yield plus risk premium approach, the cost of equity may be estimated by the following relationship:

*r _{e}* =

Where:

*r _{e}* = the cost of equity

*r _{d}* = bond yield

Risk premium = compensation which shareholders require for the additional risk of equity compared with debt

If a company’s before-tax cost of debt is 4.5% and the extra compensation required by shareholders for investing in the company’s stock is 3.2%, then the cost of equity is simply 4.5% + 3.2% = 7.7%.

QuestionA company’s current share price is $11.24, and it intends to pay a dividend of $1.38 next year. Using the dividend discount model and assuming a constant growth rate of 5%, what is the company’s cost of equity?

- 17.28%
- 16.38%
- 9.58%

SolutionThe correct answer is

A.Using the equation:

$$ \begin{align}

{ r }_{ e } & =\frac { { D }_{ 1 } }{ { P }_{ 0 } } +g \\

& =\frac { $1.38 }{ $11.24 } + 0.05 \\

&= 0.12278 + 0.05 = 17.28\% \\

\end{align}$$