Estimating the Cost of Equity Capital and the Overall Cost of Capital

This chapter examines risk-free rate and risk premium components in detail, dividing the equity risk premium into subcomponents. It also addresses the cost of preferred stock and debt, thus concluding with an overall cost of capital for the firm, which is called the weighted average cost of capital (WACC). Noteworthy, a risk-free rate is the return available, as of the valuation date, on a security that the market generally regards as free of the risk of default. While in the case of equity risk premium, for an equity investment, the return on the investment that the investor will realize usually has two components. First, is the distribution during the holding period, and second is the capital gain or loss in the value of the investment. Furthermore, this chapter also discusses the Capital Asset Pricing Model (CAPM), the most widely used method for estimating the cost of equity capital.