FINANCE • COST OF CAPITAL
Cost of Equity: CAPM Formula, Example, and Limitations
Cost of equity is the return investors require for bearing the risk of owning a business. It is an opportunity cost used in valuation and investment decisions, even when the company pays no dividend. It is not an invoice, a guaranteed investment return, or the historical return on book equity.
By Taylor Frizzell, MBA • October 21, 2026
The CAPM formula
Cost of equity = Risk-free rate + Beta × Equity risk premium
The capital asset pricing model (CAPM) links required return to systematic risk—the risk associated with broad market movements that diversification cannot eliminate. It is a model with important assumptions, not a direct observation of a company’s true cost of equity.
- Risk-free rate: a baseline yield in the same currency as the forecast. Match the maturity reasonably to the valuation horizon and consider whether the instrument has meaningful default risk.
- Beta: estimated sensitivity of equity returns to the market. A beta of 1.2 means estimated market sensitivity is greater than a beta of 1; it does not mean every price move is exactly 20% larger.
- Equity risk premium: the extra expected return for the equity market over the risk-free rate. If expected market return is 9% and the risk-free rate is 4%, the premium is 5%, not 9%.
Worked example: 10% cost of equity
Assume a hypothetical risk-free rate of 4%, beta of 1.2, and equity risk premium of 5%. These inputs are teaching assumptions, not current market estimates.
4% + 1.2 × 5% = 10%
For $500,000 of market-value equity, 10% represents a $50,000 annual required-return equivalent. That does not require a $50,000 cash dividend each year. Investors may receive their economic return through distributions and changes in equity value, and actual results can be negative.
Connect cost of equity to WACC
Assume market-value equity of $600,000, debt of $400,000, a 6% pretax debt cost, and a 25% marginal tax rate. Assuming interest deductions are usable:
WACC = 60% × 10% + 40% × 6% × (1 − 25%) = 7.8%
Cost of equity is one input to WACC. Match FCFF with an appropriate WACC and FCFE with an appropriate cost of equity. Discounting equity cash flows at WACC mixes financing perspectives. See the WACC guide for the broader calculation.
Sensitivity: avoid false precision
Hold the risk-free rate at 4%. The table shows how estimated required return changes with beta and the market premium.
| Beta | 4% premium | 5% premium | 6% premium |
|---|---|---|---|
| 0.8 | 7.2% | 8.0% | 8.8% |
| 1.2 | 8.8% | 10.0% | 11.2% |
| 1.6 | 10.4% | 12.0% | 13.6% |
Use a defensible range rather than selecting the rate that produces a preferred valuation. Keep forecast currency, nominal versus real assumptions, valuation date, and risk treatment consistent.
Estimate beta thoughtfully
A historical regression beta depends on the market benchmark, sampling frequency, and measurement window. An unusual period or a change in the business can make it a poor forecast. Debt amplifies equity risk, so comparing highly leveraged and lightly leveraged peers without adjustment can mislead.
For a private business, analysts may use comparable public companies, remove the effects of peer leverage, and relever for the target financing policy. That requires assumptions about taxes, debt risk, and comparability. Do not copy a public peer’s beta or add overlapping size, country, and company-risk premiums without understanding what each adjustment captures.
Cost of equity versus other measures
| Measure | Meaning |
|---|---|
| Cost of equity | Required forward-looking return on equity risk |
| ROE | Accounting net income relative to book equity |
| Dividend yield | Annual dividends relative to share price |
| Cost of debt | Required return on borrowing, with different priority and risk |
Common mistakes
- Using 5 instead of 5% in a spreadsheet. With 4%, 1.2, and 5% in B2:B4, use
=B2+B3*B4. - Subtracting the risk-free rate twice from a premium already stated as an excess return.
- Applying the interest tax shield to cost of equity. The simple WACC tax adjustment applies to debt, subject to tax assumptions.
- Using book-value weights automatically when estimating a market-based WACC.
- Using one company-wide rate for a project with materially different operating risk.
- Interpreting a higher required return as a promise of higher realized performance.
Frequently asked questions
Does a company without dividends have a cost of equity?
Yes. Owners still commit capital that could be invested elsewhere. Dividend policy does not remove that opportunity cost.
Can cost of equity be measured exactly?
No. CAPM and other approaches estimate an unobservable required return. Historical inputs, forward estimates, and model assumptions introduce uncertainty.
Is CAPM always the best method?
No single model solves every case. Analysts may compare other approaches, including dividend-based models when distributions and growth assumptions are suitable. Explain the method, limitations, and sensitivity.
Continue learning and sources
Read Capital Structure, DCF Valuation, and Sensitivity and Scenario Analysis. Return to the Finance hub.
Primary educational sources: CFA Institute: Portfolio Risk and Return, Part II; CFA Institute: Cost of Capital, Advanced Topics. Calculations above are original hypothetical examples. Educational content; apply assumptions appropriate to the business and valuation date.