Finance · level 1
Cost of equity (CAPM)
Two multiplications and an addition. Beta scales the market premium, the risk-free rate sets the floor — this is the number that feeds every DCF you will build.
Worked example: Risk-free 2%, equity risk premium 7%, β = 0.7. Cost of equity?
rf2%
β × ERP4.9%
cost of equity6.9%
Step by step
- 1
CAPM
rₑ = rf + β × ERP
- 2
Risk premium earned
0.7 × 7% = 4.9%
- 3
Add the risk-free rate
2% + 4.9% = 6.9%
Risk-free 2%, equity risk premium 7%, β = 0.7. Cost of equity? = 6.9
The theory behind it
Intuition
Cost of equity = risk-free rate plus payment for the risk you cannot diversify away. Only beta risk is paid for.
Common pitfalls
- ×Adding company-specific risk to beta risk twice.
- ×Using a historical beta for a company whose leverage has changed.
In the interview
The equity leg of a WACC round.