To find the cost of equity, one option is to use the CAPM formula (the capital asset pricing model) Here we have it on the screen and we're going to break it down into its component parts Risk free returns plus your risk premium (Rm-Rf), times by the Beta So what are these individual parts? Well my risk free returns is the return investors require for taking no risk This means we want to invest in something that is riskless. Typically this is a 10 year government bond So the return on that or the yield on that, just to take an example might be 2% However I'm not trying to find the return on a government bond, I'm tying to find the return on a corporate bond So I now need to add on the risk premium for taking equity risk i.e for investing in a corporate So your risk premium is the additional risk investors require to invest in the overall stock market So the stock market has extra risk when compared to government bonds Okay so that's getting me closer to the company I'm looking to invest in Let's say my risk free returns were 2% and the risk premium is 5%, so I'm currently up to 7% However, the company I'm investing in, isn't necessarily going to have the same risk as the stock market overall Thus I need to look at the additional investors require to compensate for non diversifiable, stock specific risk And the Beta looks at that. The Beta says, if your stock is less sensitive than the market, the market goes up 10 and your company stock only goes up 8 Then you would have a Beta of 0.8. You'd be less sensitive than the market This would typically be quite a defensive stock, something that is a necessity of life; maybe bread, maybe food manufactures If you're looking for something which had Beta greater than the stock market Generally these seem to be luxuries, so maybe air travel, maybe fashionable clothing If we had a Beta of 0.8, then that means I times that 0.8 by my risk premium of 5. And that would get be 4 I'd add that onto the risk free returns of 2 and now I've got a cost of equity. Add it all up, 6%