Investments are no joke, and one must not take them lightly. The littlest shift in the market can cause the stock price to go up or down, thereby determining your gains or losses from the investments you made. A few terms that decide whether or not one should invest in an asset are Cost of Equity and Cost of Capital.
Cost of Equity vs Cost of Capital
The main difference between the Cost of Equity and the Cost of Capital is that the Cost of Equity is the returns earned from investments. In contrast, the Cost of Capital is the expense the firm must pay to raise funds. However, the Cost of Equity assists in estimating the Cost of Capital.
Cost of Equity is the returns needed by the company to make sure that the investments that have been made meet the requirements for capital returns. It is like a barter system between the company and the market. The company compensates for its ownership of the asset with its Cost of Equity.
The Cost of Capital is a mixed weighted average of the Cost of debt and the Cost of Equity expected by a company. A company uses the Cost of capital to decide whether a project is worth the expenditure on its resources. Investors use it for a similar purpose.
Comparison Table Between Cost of Equity and Cost of Capital
Parameters of Comparison | Cost of Equity | Cost of Capital |
Definition | It is the returns expected by an investor. | It is the amount paid by the company to raise more funds. |
Calculation Method | The Cost of Equity can be calculated using two methods- the dividend capitalization method and the capital asset pricing method. | The Cost of Capital is calculated by the WACC method. |
Decision-making | It plays a small role in decision-making about investments. | It plays a major role while decision-making about investments. |
Condition for benefits | The returns must be more than the cost of capital. | The cost of capital must be less than returns. |
Incorporates cost of debt | The cost of equity does not incorporate the cost of debt. | Both the cost of equity and cost of debt are taken into consideration. |
What is Cost of Equity?
The Cost of equity is essentially the rate of return a shareholder receives on an equity investment they have made. It is a value that essentially means the amount one may earn by investing in another asset with equal risk. It is the number that will persuade an investor to invest in the company’s assets.
The Cost of equity is an essential aspect of stock evaluation. There are two ways to assess the Cost of Equity; the capital asset pricing method or the dividend capitalization method. But the dividend method can only be applied if the company pays dividends. The capital asset pricing method is one where it contemplates the risk involved in the investment concerning the market.
Cost of equity is basically the attractiveness of the project in which the firm would want the investors to invest. As a company, it is the rate of return required to persuade an investor and investor. It is the rate of return expected by you to invest in the assets of a firm or company.
Depending on how one calculates it, the cost of equity depends on the dividends paid by the company or the risk associated with the market.
What is Cost of Capital?
When the Cost of Equity meshes with the cost of debt and their weighted average is taken, it is known as the Cost of Capital. Capital is basically a standard that decides whether a project is worth its resources or whether investing is worth the risk of its returns.
Companies arrange for finances in two ways; by acquiring debt or through equity. Thus, the Cost of capital is also solely dependent on the financing method. In most cases, companies use a mixture of the two approaches, in which case the Cost of Capital is determined by their weighted average.
A company’s decisions for project investments must generate a return that exceeds the Cost of Capital so that investors return. The Cost of Capital is estimated by the procedure called Weighted Average Cost of Capital (WACC). This formula takes into consideration the weighted proportionality of Cost of equity and cost of debt.
The Cost of Capital is one of the most essential factors in the decision-making process of investments made in capital projects. It is the standard below which the project must not be invested in as the investor will not get any benefits if the returns fall.
Main Differences Between Cost of Equity and Cost of Capital
- The main difference between the Cost of equity and the Cost of capital is that the cost of equity is the value paid to the investors. In contrast, the Cost of Capital is the expense of funds paid by the company like interests, financial fees, etc.
- The Cost of equity can be calculated using two techniques – the capital asset pricing method and the dividend capitalization method. The Cost of Capital is calculated by the WACC method.
- The Cost of capital plays a more critical role while making decisions about capital projects than the Cost of equity.
- The Cost of Capital must always be less than the number of returns calculated by the Cost of equity for investors to make an investment.
- The Cost of equity is a component of the Cost of Capital.
- The Cost of equity does not consider debt, whereas the Cost of
Conclusion
As said before, investments are always risky. One must always exercise caution with where they put their money into. Cost of equity and Cost of Capital are two crucial terms in the finance world that help get more information about the risks involved with potential investments.
The Cost of capital tells you the amount required to raise new money. The cost of equity tells the investors the number of returns they should expect, considering the percentage of risk involved in the market.
References
- https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1475-679X.2006.00209.x
- https://link.springer.com/article/10.1023/B:RAST.0000028188.71604.0a