What is the cost formula of equity capital?

1. Cost of equity capital = risk-free interest rate+risk premium

2.rs=rRF+β×(rm-rRF), where: rRF-risk-free interest rate; Beta-the beta coefficient of the stock; Rm-average risk stock return rate; (RM-RRF)- market risk premium; β×(RM-RRF)- Risk premium of stock.

Estimation of risk-free interest rate: yield to maturity, a long-term government bond listed and traded, should be chosen as the representative of risk-free interest rate.

3. Market risk premium =rm-rRF: usually defined as the difference between the average market rate of return and the average rate of return of risk-free assets in a long historical period.

The cost of equity capital is the cost and expense paid by investors to obtain equity capital of enterprises. This index is of great significance and influence to measure the efficiency of equity investment. In an active and complete capital market environment, the measurement of the cost of equity capital is closely related to the capital asset pricing model and the residual income discount model. Due to strict assumptions, the application of traditional capital asset pricing model in empirical research has decreased. Later, many scholars improved it. Blake (1972) proposed to abandon the assumption that investors can borrow at risk-free interest rates. Merton1973 put forward a two-factor capital asset pricing model. The multi-period capital asset pricing model (ICAPM) is based on time continuity and includes several CAPM models. The establishment of ICAPM improves the applicability of the capital asset pricing model to the capital market.

Ross (1976) basically abandoned the hypothesis of CAPM and put forward the arbitrage pricing theory in economic theory. The hypothesis and research ideas of this theory are completely different from CAPM. Ross believes that the return on assets is affected by at least three factors. But the choice of influencing factors has always been the focus of debate in theoretical circles. In 1992, Fama and French put forward three-factor model and discounted cash flow model. These theoretical viewpoints and assumptions have laid a theoretical foundation for measuring the cost of equity capital.

Another research direction of measuring the cost of equity capital is the residual income pricing model, which was put forward by Gebhard. Lee and Swaminathan in 2003. The residual income pricing model is more convincing than the traditional measurement model in predicting the cost of equity capital.