What is the cost of equity?

Cost of equity is the return that investors expect in exchange for owning a share of your business. It's not a fee you pay out, like interest on a loan. Instead, it represents the minimum return shareholders require to justify the risk they're taking by investing in your company, rather than putting their money elsewhere. If your business doesn't deliver that return, investors will move their money somewhere that does.

For founders and finance managers, understanding the cost of equity matters because it underpins business valuation, informs capital structure decisions and helps quantify what equity finance actually costs you, even when no cash changes hands. Understanding it also helps when deciding on equity finance vs debt finance for your business.

Why the cost of equity matters

Comparing funding options: equity vs debt

When a business takes on investor funding, the equity given away has a real cost: future profits and control. That cost is the cost of equity. When a business takes on debt finance, such as a business loan, the cost is the interest rate, which is fixed, transparent and doesn't dilute ownership. Comparing the two makes the true cost of each funding route clearer. Debt finance, such as a business loan, lets owners raise funds without giving away equity or sharing future profits, and the interest rate is known from day one.

Valuation and investment decisions

Cost of equity feeds directly into business valuation models, particularly discounted cash flow analysis. It's one of the inputs to the Weighted Average Cost of Capital (WACC), a metric used by investors and analysts to assess whether a business is generating returns above the cost of its funding. A high cost of equity signals that investors see the business as risky and expect a higher return.

The cost of equity formula

There are two main ways to calculate the cost of equity. Which you use depends on whether your business pays dividends and how much market data is available.

Capital Asset Pricing Model (CAPM)

The most widely used method is the Capital Asset Pricing Model (CAPM). The formula is:

Cost of equity = Risk-free rate + Beta x (Market return - Risk-free rate)

The risk-free rate is the return on a risk-free investment, usually represented by the yield on UK government gilts (gilts). Beta is a measure of how volatile your company's returns are relative to the market. A beta of 1 means your stock moves in line with the market; above 1 means more volatile; below 1 means less volatile.
Market return is the expected return from the overall stock market. 

Dividend capitalisation model

The dividend capitalisation model (also called the Gordon Growth Model) is used when a company pays regular dividends. The formula is:

Cost of equity = (Next year's dividend / Current share price) + Dividend growth rate

Which method should you use?

Use CAPM when your business doesn't pay dividends, or when you want to reflect wider market risk in your calculation. It's the standard approach for most businesses, including those raising equity for growth. Use the dividend capitalisation model when your company has a consistent dividend history and a stable growth rate. For most UK SMEs raising their first rounds of equity finance, CAPM is the more practical starting point.

What influences your cost of equity

Business risk, the stage of growth your business is at and the market conditions can all influence your cost of equity. Volatile or uncertain revenue and early-stage businesses usually have a higher rate of cost equity.

The sector you’re in and the capital structure (how much debt your business carries, how financially leveraged it is etc) can also affect the cost of equity that your business may be offered. Different industries and structures carry different levels of risk.

Cost of equity vs cost of debt

The cost of equity is almost always higher than the cost of debt, and for good reason. Debt holders get paid first in the event of a business failure. Equity holders are last in the queue and carry the highest risk. To compensate for that risk, they demand a higher expected return.

Comparison table

For small businesses looking to raise funds without diluting ownership, the lower and more predictable cost of debt is often the more attractive route. A business loan provides a fixed rate from the outset, so you know exactly what the finance costs.

Cost of equity vs cost of capital (WACC)

Cost of equity is one component of a broader metric called the Weighted Average Cost of Capital, or WACC. WACC blends the cost of equity and the cost of debt in proportion to how much of each a business uses to fund itself. It gives a single figure that represents the minimum return a business must generate across all its capital to satisfy both equity investors and debt holders.

To see how this works, imagine a business is funded with £1,000 total.

• Equity: £600 (which is 60%) at a 9% cost = £54

• Debt: £400 (which is 40%) at a 5% cost = £20

• Total Cost: £54 + £20 = £74.

Because £74 is exactly 7.4% of the original £1,000, the overall WACC is 7.4%. 

This means the business needs to generate at least a 7.4% return on its assets to create value. These are illustrative figures only.

How UK businesses use cost of equity in practice

For most small businesses, cost of equity is relevant in three main scenarios: when pitching to investors (who will use it to assess whether your projected returns are sufficient), when evaluating whether to take on equity finance versus debt (since knowing what equity costs helps compare the two honestly), and when building a financial model or business plan that requires a discount rate.

If you're at the stage where you're comparing equity and debt finance, it's worth being clear on what you're giving up with each. Debt has a known, fixed cost. Equity's cost is harder to see but real: it's the share of your future profits, and the control, that you hand over in exchange for investment.

Find out more about business loans with Funding Circle.

FAQs

What is a typical cost of equity for a UK small business?

There's no fixed answer, it varies significantly by sector, stage and risk profile. Early-stage businesses seeking angel or venture investment may face equity costs of 20% or above, reflecting the higher risk. More established SMEs may see lower figures, in line with market comparables. CAPM can provide a useful starting estimate, but all figures should be treated as illustrative.

Can you calculate the cost of equity without paying dividends?

Yes. The dividend capitalisation model requires a dividend history, but CAPM doesn't. Most growing SMEs don't pay dividends, so CAPM is typically the more relevant formula. It requires an estimate of beta, which for unlisted companies means finding comparable listed businesses and using their beta as a proxy.

Why is the cost of equity higher than the cost of debt?

Because equity holders take on more risk. In a liquidation, debt holders are repaid first. Equity holders get what's left, which may be nothing. To compensate for that risk, they expect a higher return than lenders do. This is why interest rates on business loans are typically lower than the returns equity investors seek.

What is the difference between cost of equity and WACC?

Cost of equity is the return expected specifically by equity shareholders. WACC blends the cost of equity and the cost of debt, weighted by how much of each makes up the business's total funding. WACC is used to assess whether a business is generating returns above its total cost of capital, across all funding sources.

Disclaimer

26/08/26 – While we want to help as much as we can, the information found here is provided solely for informational purposes and should not be considered financial or legal advice. To the extent permitted by law, Funding Circle does not accept any liability for any loss or damage which may arise directly or indirectly from the use of, or reliance on, the information contained here. All information is correct at time of publishing, and customers should do their own research before making financial decisions. If you have any questions, please speak to your professional adviser or seek independent legal advice.