Cost of Equity Calculation Example
Let's put the CAPM and Build-Up Method side-by-side using a real companyβTeslaβto illustrate how different inputs affect your output.
Recap of the CAPM Formula
CostΒ ofΒ Equity=Rfβ+Ξ²Γ(RmββRfβ)
Where:
- Rfβ = 4.31% (risk-free rate);
- Ξ² = 2.58 (Tesla's beta);
- Rmβ = 9% (market return).
With these values:
CostΒ ofΒ Equity=4.31%+2.58Γ(9%β4.31%)β16.14%
The high beta reflects Tesla's volatility, which significantly amplifies the equity costβsomething investors demand as compensation for risk.
Build-Up Method in Parallel
Let's assume for comparison:
- Risk-free rate: 4.31%;
- Equity Risk Premium: 5%;
- Size Premium: 1%;
- Industry Risk Premium: 2%;
- Company-Specific Premium: 1.5%.
CostΒ ofΒ Equity=4.31%+5%+1%+2%+1.5%=13.81%
Even though both methods are valid, they yield different results. The Build-Up Method often produces more conservative estimates for private firms or startups where beta isn't well-defined.
- CAPM is dynamic and market-based, suitable for public companies with reliable data;
- Build-Up is additive and more controllable, ideal for private or high-uncertainty contexts;
- The cost of equity is not a fixed numberβit reflects your assumptions and context.
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Cost of Equity Calculation Example
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Let's put the CAPM and Build-Up Method side-by-side using a real companyβTeslaβto illustrate how different inputs affect your output.
Recap of the CAPM Formula
CostΒ ofΒ Equity=Rfβ+Ξ²Γ(RmββRfβ)
Where:
- Rfβ = 4.31% (risk-free rate);
- Ξ² = 2.58 (Tesla's beta);
- Rmβ = 9% (market return).
With these values:
CostΒ ofΒ Equity=4.31%+2.58Γ(9%β4.31%)β16.14%
The high beta reflects Tesla's volatility, which significantly amplifies the equity costβsomething investors demand as compensation for risk.
Build-Up Method in Parallel
Let's assume for comparison:
- Risk-free rate: 4.31%;
- Equity Risk Premium: 5%;
- Size Premium: 1%;
- Industry Risk Premium: 2%;
- Company-Specific Premium: 1.5%.
CostΒ ofΒ Equity=4.31%+5%+1%+2%+1.5%=13.81%
Even though both methods are valid, they yield different results. The Build-Up Method often produces more conservative estimates for private firms or startups where beta isn't well-defined.
- CAPM is dynamic and market-based, suitable for public companies with reliable data;
- Build-Up is additive and more controllable, ideal for private or high-uncertainty contexts;
- The cost of equity is not a fixed numberβit reflects your assumptions and context.
Thanks for your feedback!