WACC - the cost of equity

Cost of equity

Since your cost of equity is based on market expectations, you estimate the return a shareholder expects to hold on to your stock. A common calculation method is the capital assets pricing model (CAPM).

cost of equity capital = risk free rate of return + (stock beta x market risk premium)

Risk Free Rate of Return

The risk free rate of return is usually a long term US Treasury Bond, e.g., the 10 or 20 year bond. It's a "mature" assessment of risk. The day you buy it, you know exactly what you'll make and when you will get your principal back. (On 4/23/2003, a 20 Year Treasury Bond rate of return was 4.89%. See the Federal Reserve Board's H15 update for current rates. The 2010 data is disturbing.)

Market Risk Premium

The market risk premium is the return stock investors want beyond the risk free rate of return. A ball park number is 7%, the average premium expected for stocks from 1926-1999. We can calculate it using an industry rate available from Ibbotson Associates or a market index's historical rate of return.

In April 2003, the Russell 3000, a broad market index, for the last ten years had a 8.16% return and the S&P 500, a large cap index, had a 9.66% return for the last ten year. On 4/23/2003, the market risk premium using the Russell 3000 less the 20 year US Treasury bond rate is

3.27% = 8.16% (index return) - 4.89% (risk free return)

"The boss" thought: this calculation requires us to make choices about where to get the risk premium, changes with the market, appears more art and experience than science, and 3.27% is about half of 7% - the historical ball park.