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How do you calculate the cost of equity?

To calculate a company’s cost of equity, we typically use the Capital Asset Pricing Model (CAPM).  The CAPM formula states the cost of equity equals the risk free rate plus the multiplication of Beta times the equity risk premium.  The risk free rate (for a U.S. company) is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond.  Beta (See the following question on Beta) should be levered and represents the riskiness (equivalently, expected return) of the company’s equity relative to the overall equity markets.  The equity risk premium is the amount that stocks are expected to outperform the risk free rate over the long-term.  Prior to the credit crises, most banks tend to use an equity risk premium of between 4% and 5%.  However, today is assumed that the equity risk premium is higher.

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