Meaning- Cost of equity
A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.
Cost of equity is a component of overall cost of capital of the firm. Cost of capital is the minimum return firm has to generate from its business. It is easy to calculate cost of capital for the firm rather than for its divisions. The reason for the same is that funds are raised by the firms not by the divisions. Risk associated with the divisions can be different from the risk owned by firm’s business alone. If this is true required return for the divisions will be different from the return generated by the firm.
Article- Finnigan Corporation
In the above article business is divided in two divisions The Instruments and Disc subsidiary and raised capital by one-third of debt and two-third from equity.
Firm cost of capital is 14.5 %, which is the weighted average of cost of debt (Rd=4.4%) and cost of equity (Re=19.4%)
Rd= .092(1-.52) = 4.4%
Re = .06 + (.13 - .06) 1.7 + .015 = 19.4%.
Rd+e = .33 (.044) + .67 (.194) = 14.5%
In practice, division operated by the firms have different risk so required rate of return for them is also different because of different cost of capital than firm.
Divisional betas are calculated by pure play approach in which we find the proxy companies operates solely into the same product in which the firm’s division operates and then takes the average of betas of all the proxy companies, but it is very difficult to identify similar company with a same single product also sometime division can be more riskier than proxy company because of its operating risk so it may be chance that beta value determined by proxy companies does not reflect true picture for the division as in this article. Capital structure for both the division is assumed to be same also market risk premium and risk free rate will be the same for each of the division only beta value...