The required rate of return for equity is the return a business requires on a project financed with internal funds rather than debt. The required rate of return for equity represents the theoretical return an investor requires for holding the firm’s stock. Generally, the minimum required rate of return for equity, also known as the company’s cost of equity, can be determined by at least two different methods, the dividend capitalization model and the capital asset pricing model.
The dividend capitalization model and capital asset pricing model can be used to determine the rate of return for equity.
Exploring Dividend-Capitalization Model
The required rate of return for equity of a dividend-paying stock is equal to ((next year’s estimated dividends per share/current share price) + dividend growth rate).
For example, suppose a company is expected to pay an annual dividend of $2 next year and its stock is currently trading at $100 a share. The company has been steadily raising its dividend each year at a 5 percent growth rate. The required rate of return for equity of the shares is (($2/$100) + 0.05), or 7 percent.
Any capital investment made by the company using internal funding should have an expected rate of return no lower than 7 percent.
Using the Capital Asset Pricing Model
The capital asset pricing model is useful for estimating required rate of return for equity when a stock pays no dividends. To use this model, you must use a stock’s beta, which is a measure of its price volatility relative to that of the overall stock market.
The other two variables needed for this model are the risk-free rate of return (typically, the interest on short-term Treasury debt) and the market rate of return (the long-term annual return on the S&P 500 stock index often serves as the proxy for this figure). Under this model, the required rate of return for equity equals (the risk-free rate of return + beta x (market rate of return – risk-free rate of return)).
Capital Asset Pricing Model Examples
Imagine a company with a beta of 1.10, which means it is more volatile than the general stock market, which has a beta of 1.0. The current risk-free rate is 2 percent, and the long-term average market rate of return is 12 percent. The required rate of return for equity for the company equals (0.02 + 1.10 x (0.12 - 0.02)), or 13 percent.
The required rate of return for equity increases with higher betas, meaning that investors require a higher rate of return to compensate for the additional risk of holding the volatile stock.
Applying the Required Rate of Return for Equity
A business uses the required rate of return for equity as a discount factor to evaluate the returns on a business project by calculating its net present value. The net present value applies the discount factor to each cash flow expected from or to the project, properly weighted for the timing of the cash flow.
Only projects with a positive net present value will earn a return in excess of the required rate of return for equity. If a company has a choice among several projects, it might choose the one with the highest positive net present value, all other things being equal.
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