Cost of Equity
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of return) where Beta= sensitivity to movements in the relevant market
Where:
- Es
- The expected return for a security
- Rf
- The expected risk-free return in that market (government bond yield)
- βs
- The sensitivity to market risk for the security
- RM
- The historical return of the stock market/ equity market
- (RM-Rf)
- The risk premium of market assets over risk free assets.
The risk free rate is taken from the lowest yielding bonds in the particular market, such as government bonds.
An alternative to the estimation of the required return by the CAPM as above, is the use of the Fama–French three-factor model.
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