Companies require capital to start up and run business operations. Capital maybe obtained using many methods such as issuing shares, bonds, loans, owner’s contributions, etc. Cost of capital refers to the cost incurred in obtaining either equity capital (the cost incurred in issuing shares) or debt capital (interest cost). In this article, our focus will be on equity capital. The article will provide a clear explanation of what equity refers to, cost of equity capital and how it is calculated, as well as an explanation of return on equity and calculation formula. The similarities and differences between cost of equity and return on equity are also discussed.
What is Cost of Equity?
Cost of equity refers to the return that is required by investors/shareholders, or the amount of compensation that an investor expects for making an equity investment in the firm’s shares. Cost of equity is an important measure and allows the firm to determine how much return should be paid to investors for the level of risk taken. The cost of equity can also be compared with other forms of capital such as debt capital, which will then allow the firm to decide which form of capital is the cheapest.
Cost of equity is calculated as Es=Rf + βs (RM-Rf). In this equation, Es is the expected return on the security, Rf refers to the risk free rate paid by government securities (this is added because the return on a risky investment is always higher than government risk free rate), βs refers to the sensitivity to market changes, and RM is the market rate of return, where (RM-Rf) refers to the market risk premium.
What is Return on Equity?
Return on equity is a formula very useful for shareholders and investors who invest in the firm’s equity as it allows them to see how much return they can obtain from their equity investment. Return on equity is a good measure of the company’s financial stability and profitability as it measures profits made by investing shareholder’s funds.
Return on equity is calculated by, Return on Equity = Net Income/Shareholder’s Equity. Net income is the revenue generated by a firm, and shareholder’s equity refers to the capital contributed to the firm by shareholders.
Cost of Equity vs Return on Equity
Cost of equity and return on equity are concepts closely related to one another. One of the main differences between the two is that cost of equity in the perspective of the business is a cost, and return on equity in the company’s perspective is an income. Comparison between cost of equity and return on equity can also yield important insights; a company with a return on equity higher than its cost of capital is a financially stable firm.
Summary:
• Cost of equity refers to the return that is required by investors/shareholders, or the amount of compensation that an investor expects for making an equity investment in the firm’s shares.
• Return on equity is a formula very useful for shareholders and investors who invest in the firm’s equity as it allows them to see how much return they can obtain from their equity investment.
• One of the main differences between the two is that cost of equity in the perspective of the business is a cost, and return on equity in the company’s perspective is an income.