Question

In the Apple Tree and Experience article, we have discussed several valuation options. In earnings capitalization model and discounted cash flow model, the cost of equity is used as a discount rate to estimate firm's value 1. Please define the cost of equity. What is it? 2. PE ratio can be used to estimate the cost of equity in the market. If PE is 12, what is the cost of equity estimated?

Answer 1

COST OF EQUITY

• Cost of equity is rate of return expected by the equity share holders how are invested in business
• for using the amount from the Invester organization pays return in the form of cost of equity
• cost of equity return will depends on level of risk of organization
• company generally uses equity finance and debt finance for equity return will be cost of equity and for debt interest pays
• for calculation of cost of equity difeerent formuleas there but mostly uses CAPITAL ASSENT PRICING METHOD (CAPM)

  E(R_i) = R_f + β_i * [E(R_m) – R_f]

Where:

E(R_i) = Expected return on asset i

R_f = Risk-free rate of return

β_i = Beta of asset i

E(R_m) = Expected market return

2) PE RATIO =MARKET PRICE PER SHARE/EARNING PRICE PER SHARE =12

THEN Cost of Equity = Earnings/Price + Earnings Growth

EARNING/PRICE =COST OF EQUITY

1/12 = .0833