Description
Businesses need capital to fund growth via investing in new projects. However, unitholders require a certain return on the money they invest in the business. After all, why should they invest their hard earned cash in a business venture that could possibly fail? They could easily purchase safe, dependable government bonds and not have to worry about whether they will get their money back. So, the firm needs to make it worth their while. That is, they need to compensate investors for the additional risk they are taking on by investing in the business.
We can reasonably assume that the annual rate of return on government bonds (treasuries) is the “risk-free” rate, since we can be confident the US government will pay us our money back. However, investors will want an additional return above and beyond the risk-free rate if they are going to fund the project. This incremental return is called the equity “risk-premium”, and it varies based on the underlying volatility and risk of a given firm. The sum of the two is the firm’s cost of equity capital, and is used when calculating the rate used for discounting future cash flows.
Calculation
Cost of Equity Capital (%) = Treasury Rate + Risk Premium