Estimating the Cost of Common Stock

The cost of common equity is represented as re, and it is the rate of return required by the common shareholders.

The cost of common equity can be measured using the following methods:

1. Capital Asset Pricing Model (CAPM)

2. Dividend Discount Model

3. Bond Yield plus Risk Premium Method

Let's discuss each of these methods in some depth.

1. Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model is a popular asset-pricing model in Finance. It is used to determine the expected rate of return of a risky asset. It says that the expected return on a risky asset is equal to the risk-free rate plus a risk premium.

The risk premium is a measure of non-diversifiable risk and is calculated using the asset’s Beta. CAPM considers only systematic risk (non-diversifiable risk) as the security specific risk (unsystematic risk) can be diversified away.

According to the CAPM model, the expected return on a security is given as follows:

$E(r)=R_{f}+\beta\left (E(R_{m}) - R_{f} \right )$