In the Cost of Equity formula, which component is added to the risk-free rate?

In the Cost of Equity formula, the component that is added to the risk-free rate is the product of BETA and the Market Risk Premium. This is because the Cost of Equity is generally calculated using the Capital Asset Pricing Model (CAPM), which states that the expected return on equity (cost of equity) equals the risk-free rate plus a risk premium. The risk premium is determined by multiplying BETA, which measures the sensitivity of the stock's returns relative to the market, by the Market Risk Premium, which is the expected excess return of the market over the risk-free rate.

Thus, this combination quantifies the additional return an investor requires for taking on the risk associated with the equity investment in comparison to a risk-free asset. By incorporating BETA and the Market Risk Premium into the cost of equity formula, investors can accurately capture the risk profile of the stock in relation to the overall market, thereby determining a more precise expected return.

This understanding highlights the importance of these components in assessing the cost of equity and helps investors make informed decisions based on risk and expected returns.