Determine cost of equity using CAPM (capital asset pricing model)
Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return – Risk-Free Rate)
The market rate of return refers to the returns generated by the market in which the ABC Company’s stock is traded.
The beta of the stock refers to the risk level of the individual security relative to the wider marker.
The risk-free rate is generally defined as the rate of return on short-term U.S. Treasury bills, or T-bills, So, the risk of losing invested capital is virtually zero
Example
Assume ABC Company trades on the Nasdaq with a rate of return of 10 percent. The company’s stock is slightly more volatile than the market with a beta of 1.3. The risk-free rate based on the three-month T-bill is 4.5 percent.
Cost of equity = 4.5 + 1.3 * (10 – 4.5)=11.65 or 11.65%
So stock investor may require return at 11.65%.
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