What is the purpose of the Cost of Equity formula?

The Cost of Equity formula serves to quantify the return required by investors for holding a company's equity. It reflects the compensation that investors expect for the risk they undertake by investing in equity rather than in less risky assets, such as bonds or government securities. Investors demand this return because equity investments are subject to greater volatility and risk compared to fixed-income investments.

By measuring the risk associated with equity investments, the formula helps companies to understand the cost of financing through equity. This understanding is crucial for making informed decisions about capital structure and investment strategies. It enables companies to assess whether their projects are expected to generate returns that exceed the cost of equity, thus ensuring they are making value-enhancing decisions.

Other options might pertain to different financial concepts but do not capture the specific purpose of the Cost of Equity formula—namely, to gauge the risk and expected return of equity investments.