Morgan Stanley’s New York office recently asked this question during a first-round interview for an investment banking summer internship: “How do you calculate cost of equity?” This is one of the most common technical questions in investment banking and private equity interviews, and getting it wrong can cost you the offer.
In this guide, we break down the cost of equity concept, walk through the CAPM formula step by step, and explain each component so you can confidently answer this question in any interview.
What Is Cost of Equity?
Cost of equity is the rate of return that equity investors require to compensate them for the risk of investing in a particular company. Think of it as the minimum return shareholders expect for putting their money at risk.
Unlike debt, which has a stated interest rate, the cost of equity is not directly observable. It must be estimated using a financial model. The most widely used model in investment banking is the Capital Asset Pricing Model (CAPM).
The CAPM Formula
The Capital Asset Pricing Model calculates the cost of equity as follows:
Cost of Equity = Risk-Free Rate + Beta x Equity Risk Premium
Or written more formally:
Re = Rf + B x (Rm – Rf)
Where:
- Re = Cost of equity
- Rf = Risk-free rate
- B (Beta) = Measure of the stock’s volatility relative to the market
- Rm = Expected market return
- (Rm – Rf) = Equity risk premium (ERP)
Breaking Down Each Component
1. Risk-Free Rate (Rf)
The risk-free rate represents the return you can earn with zero risk. In practice, this is typically the yield on a 10-year U.S. Treasury bond. The idea is that the U.S. government is considered virtually default-free, so Treasury yields represent the baseline return investors can earn without taking on credit risk.
In an interview, you can say: “For the risk-free rate, I would use the current 10-year U.S. Treasury yield.” As of early 2026, that rate is around 4.0-4.5%.
2. Beta (B)
Beta measures how much a stock moves relative to the overall market. It captures systematic risk — the risk that cannot be diversified away.
- Beta = 1.0: The stock moves in line with the market
- Beta > 1.0: The stock is more volatile than the market (higher risk, higher expected return)
- Beta < 1.0: The stock is less volatile than the market (lower risk, lower expected return)
For example, a high-growth tech company might have a beta of 1.5, meaning it tends to move 1.5x the market. A stable utility company might have a beta of 0.6. You can find beta on Bloomberg, Capital IQ, or even Yahoo Finance.
In practice, bankers often use a levered beta from comparable companies, then unlever and re-lever it to reflect the target company’s capital structure.
3. Equity Risk Premium (ERP)
The equity risk premium is the extra return investors demand for investing in the stock market over the risk-free rate. It compensates for the additional risk of owning equities versus government bonds.
The ERP is typically estimated using historical data or forward-looking models. A commonly cited figure is around 5-7%, though estimates vary. Many banks use the Duff & Phelps (now Kroll) recommended ERP as their standard reference.
Worked Example: Calculating Cost of Equity
Let us walk through a sample calculation that you could use in an interview:
- Risk-free rate (Rf): 4.0% (current 10-year Treasury yield)
- Beta (B): 1.2 (from comparable company analysis)
- Equity risk premium (ERP): 6.0%
Cost of Equity = 4.0% + 1.2 x 6.0% = 4.0% + 7.2% = 11.2%
This means equity investors in this company would require an 11.2% annual return to justify the risk of investing. This cost of equity would then feed into the WACC calculation, which is used to discount future cash flows in a DCF analysis.
Why Cost of Equity Matters in Investment Banking
Cost of equity is a critical input in several valuation methodologies:
- WACC calculation: Cost of equity is a key component of the weighted average cost of capital, which is used as the discount rate in DCF models
- Dividend discount models: The cost of equity is used directly as the discount rate for expected future dividends
- Equity valuation: Any model that values the equity portion of a company directly requires a cost of equity estimate
Getting this number wrong means your entire valuation could be off. That is why interviewers test whether candidates understand both the formula and the intuition behind it.
Common Interview Follow-Up Questions
Be prepared for these follow-up questions after explaining the CAPM formula:
- “What happens to cost of equity if beta increases?” — Cost of equity increases because the stock is riskier.
- “Why is cost of equity higher than cost of debt?” — Equity holders are paid after debt holders in bankruptcy, so they bear more risk and demand a higher return.
- “What are the limitations of CAPM?” — It assumes a single-factor model (market risk only), uses historical data for beta which may not predict the future, and the ERP is difficult to estimate precisely.
- “How does cost of equity relate to WACC?” — Cost of equity is multiplied by the equity weight in the capital structure to get the equity component of WACC.
- “What is the size premium?” — Smaller companies tend to have higher costs of equity. Some practitioners add a size premium (from Duff & Phelps data) to the CAPM result for smaller firms.
Tips for Answering in an Interview
- Start with the formula: Write it out or state it clearly: “Cost of equity equals the risk-free rate plus beta times the equity risk premium.”
- Define each component: Show you understand what each input represents and where you would source it.
- Give a numeric example: Walk through a quick calculation to demonstrate competence.
- Connect it to the bigger picture: Explain that cost of equity feeds into WACC, which is used in DCF valuations.
Related Articles
- Walk Me Through a DCF
- How to Calculate WACC: Step-by-Step Guide
- How to Explain an LBO: Leveraged Buyout Interview Question
- Breaking Into Investment Banking From a Non-Target School
- Investment Banking Networking Timeline
- Investment Banking in London Guide
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