Question

Can you please explain to me the difference between cost of equity and cost of capital? For a geared entity, how would raising equity finance impact on the cost of equity?

Answer 1

Cost of equity is the expected rate of return on the company's equity capital for the common share holders. Cost of capital is the overall cost of capital given by WACC( Weighted average cost of capital) is the average of all kinds of capital including Equity, debt and preferred stock in the structure.

The cost of equity increases on increasing debt and for a highly geared firm, the cost of equity is high . This is because cost of equity is given by adding risk free rate to beta times the market risk premium. The levered beta for a geared company is high as Levered Beta = Unlevered Beta *(1+ D/E *(1-t)). When more equity finance is raised, the D/E ratio goes down and this in turn reduces the levered beta and further decreasing the cost of equity.