The Cost of Common Equity
The cost of equity is broadly defined as the risk-weighted projected return required by investors on a company's equity in order to compensate investors for the risk they undertake. While a firm's current cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. The cost of equity can be estimated by comparing the investment to other investments with similar risk profiles. Estimates are also commonly calculated using the capital asset pricing model (CAPM).
The CAPM shows that the cost of equity is equal to the risk free rate plus a premium expected for risk. This premium is sensitized to movements in relevant markets using the beta coefficient.
Other Calculation Methods
There are other options for estimating the cost of equity outside of using the capital asset pricing model.
The risk premium is the additional rate that must be paid to common shareholders above what is paid to bond holders, given the amount of risk carried by the equity.