Think of cost of equity (Ke) as the minimum return equity shareholders demand for putting their money into a company instead of a safer alternative. The company doesn't pay this cost like it pays interest — but if it can't earn at least this rate on equity funds, the share price falls. That's why it's real, even if invisible on the P&L.
The ICAI syllabus tests three methods to calculate Ke, and you need to know when each applies:
1. Dividend Growth Model (Gordon's Model): Use this when the company pays dividends and has a stable growth rate. The formula is Ke = D₁/P₀ + g, where D₁ is next year's expected dividend (= D₀ × (1+g)), P₀ is the current market price, and g is the constant growth rate in dividends. This is the most exam-frequent method — almost every attempt has at least one DGM question. Watch out: if the question says 'dividend just paid,' that's D₀, not D₁.
2. Capital Asset Pricing Model (CAPM): Use this when beta (β) and market return data are given. The formula is Ke = Rf + β × (Rm − Rf), where Rf is the risk-free rate (usually government securities), Rm is market return, and (Rm − Rf) is the market risk premium. CAPM is conceptually important and appears in theory + numerical combos. Beta > 1 means the stock is riskier than the market; beta < 1 means less risky.
3. Earnings-Price (E/P) Ratio Approach: Simplest of the three — Ke = EPS / Market Price. Used when no dividend data is given and the firm reinvests all earnings. Less common in problems, but fair game for theory marks.
For new equity issues, the flotation (issue) cost reduces the net proceeds to the company, so P₀ is replaced by P₀(1 − f), where f is the flotation cost percentage. This slightly increases Ke because the company receives less cash per share.
In WACC calculations, Ke always uses market value weights, not book value — this trips up many students. Cost of equity is typically the highest component of WACC because equity holders bear the residual risk and therefore demand the highest return.