Question

critically examine the different approaches for computing cost of equity

Answer 1

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❏The cost of equity can be calculated by using the CAPM (Capital Asset Pricing Model) CAPM formula shows the return of a security is equal to the risk-free return plus a risk premium, based on the beta of that security or Dividend Capitalization Model (for companies that pay out dividends).

Answer 2

There are two approaches for evaluating the Cost of equity are:

1. SML approach or CAPM model

2. Bond Yield Plus Risk Premium Approach

Explanation:

• The approaches or the method in which the cost of equity could be computed as:

1. CAPM Model or SML method

Under this method or approach, the cost of equity is evaluated or determined as:

Cost of equity (Ke) = Risk free rate (Krf) + Beta × (Expected return - Risk free rate)

2. Bond Yield Plus Risk Premium Method

Under this method or the approach, it is a subjective procedure for computing the cost of equity and the formula is:

Cost of equity = Risk Premium + Yield on long term bonds

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