Cost of Equity
Definition
The cost of equity is the return equity investors require for holding a company's stock, given its risk. It is the discount rate for levered (equity) cash flows and the equity component of WACC. The standard estimate uses CAPM: cost of equity = risk-free rate + beta x equity risk premium (sometimes plus a size premium or country risk premium, by convention).
It is unobservable — unlike the cost of debt, there is no stated coupon — so it must be modeled. Alternatives to CAPM include the dividend discount model rearranged (dividend yield plus growth) and multi-factor models, but CAPM is the interview default.
The cost of equity always exceeds the (pre-tax) cost of debt for the same company: equity holders are junior to debt in the capital structure, absorb residual volatility, and have no contractual claim to payments.
Why interviewers ask
"How do you calculate the cost of equity?" and "why is the cost of equity higher than the cost of debt?" (junior claim, residual risk — plus no tax deduction) are staples. The trap is being unable to explain why equity is riskier, or forgetting that levering up raises the cost of equity through higher beta.
Related terms
Interviews don't test definitions — they test recall under pressure.
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