Equity is an importance source of financing for any firm. Usually a firm relies more on equity than any other form of financing because it is easier to obtain and is better than debt financing. It is better than debt financing, because there is no fixed charge on the use of firms, and unlike debt financing who can make the owner’s liable for their losses, the equity owners can lose only their investment in the company.
One of the most important ways to price the cost of equity is by using the Capital Asset Pricing Model (CAPM). CAPM uses the beta of the firm or its riskiness as compared to the other assets in the market or the other shares. It also takes into account the risk premium on the stock. The higher the risk premium, the higher will be CAPM and the cost of equity. It also takes into account the risk-free rate. This is what the equity providers can get by investing in government securities. Equity providers try to get more than risk free rate, because they are taking a risk by investing in a private company. Hence, the cost of equity is always greater than risk-free rate investments.
The other factor used to estimate the cost of equity is by using Discounted Cash Flow method. Here the future expected cash flows of the firm are discounted back in order to determine the value of the firm. It is then divided by the outstanding shares of the company, to arrive at the price of each share. This is how DCF is used for determining the cost of equity.
References
Allee, K. (2008). ESTIMATING COST OF EQUITY CAPITAL WITH TIME-SERIES FORECASTS OF EARNINGS. Michigan State University, 1(1), pp.23-30.
Koloucha, P. and Novak, J. (2010). Cost of Equity Estimation Techniques Used by Valuation Experts.JES Working Paper, 1(1), pp.10-17.
