What is the Cost of Equity Premium?
The Cost of Equity Premium or Company Specific Risk Premium refers to an additional premium added to the base cost of equity to account for company-specific risks, country risks, or other idiosyncratic risks not fully captured by standard market risk models like the Capital Asset Pricing Model (CAPM).
How is the Cost of Equity Premium Used in CAPM?
The Cost of Equity Premium is an additional component to the CAPM formula:
Where:
rf: Risk-free rateβₑ: Levered BetaMRP: Market Risk PremiumCSRP: Company-Specific Risk Premium or Cost of Equity Premium
The higher the Cost of Equity Premium, the higher the Cost of Equity (rₑ), which in turn increases WACC
Cost of Equity Calculation
The Capital Asset Pricing Model (CAPM) or its variations are typically used to calculate the Cost of Equity:
Where:
rf: Risk-Free Rateβₑ: Levered Beta, which scales the MRP based on the company’s market sensitivityMRP: Market Risk PremiumCSRP: Company-Specific Risk Premium or Cost of Equity Premium
Why is the Cost of Equity Premium Important in WACC?
Addresses Unique Risks:
While beta captures market-wide risks, CSRP adjusts for company-specific risks that might not be diversified away in a portfolio.
Refines Cost of Equity:
Adding CSRP ensures the Cost of Equity better reflects the risks investors perceive in the company.
Impact on WACC:
A higher CSRP increases WACC, which raises the hurdle rate for investment decisions and lowers the present value of future cash flows in valuation.
Crucial for Smaller or Riskier Firms:
Smaller companies, start-ups, or firms with unique challenges often face risks not adequately captured by market-based metrics like beta.