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Definition: Cost of Equity Ke
Cost of equity (Ke) is the rate of return that investor who has invested his capital in an organization will get in return for the risk he is taking of the company not being successful. Each shareholder and investor who has invested whatever amount of capital gets return as per Ke.
It is different form cost of debt as cost of debt is the return which a lender gets from the cooperation. Firms total cost of capital is calculated by taking weighted average of cost of debt and Ke.
CAPM (Capital Asset Pricing Model) is the most used model of finding out the theoretical value of Ke. Following is the equation used to calculate Ke:
Ke = Rf + β (Rm -- Rf)
Ke = Cost of Equity
Rf = Risk Free Rate; usually the rate of return for Treasure bills and Treasure bonds, since these are known to be most risk free investment
β = Beta
Rm = Expected return on the market
Higher the risk associated with the investment in an organization, higher the Ke which the organization needs to pay to its investors. The value of Ke and cost of debt lets management makes decision regarding which source of financing to be used for near and far future.