CFA Level I Exam · Equity Instrument Features
Equity Risk and the Role of Equity in Company Financing
Updated 7 October 2026 · Fact-checked
Equity is the residual claim on a company's assets, so it carries more risk than debt and demands a higher return. Book value of equity is the accounting figure; market value is share price times shares outstanding. ROE = net income ÷ average book equity. Cost of equity is the minimum return shareholders require.
Understand Equity Risk and the Role of Equity in Company Financing
Equity is ownership. A shareholder owns the residual claim: what is left after creditors are paid. Debt holders get contractual interest and principal. Shareholders get dividends only if the board declares them, and they share in the upside without a cap.
That is why equity is riskier than debt and, usually, riskier than preferred shares. In liquidation, shareholders rank last. Their returns are uncertain and their prices are more volatile. Investors accept this only if the expected return is higher. Equity also has no maturity date, so the issuer never has to repay the capital.
For the company, equity is a source of financing that has no mandatory payments and no default trigger. It is a cushion for creditors. It can be raised by issuing new shares, or built up by retaining earnings.
Book value of equity is total assets minus total liabilities on the balance sheet. It reflects historical cost and accounting rules. Market value of equity (market capitalization) is share price × number of shares outstanding. It reflects expectations about future cash flows. The two differ, often by a lot. Market value above book value suggests the market expects strong future returns, or that assets are carried below their economic value.
Return on equity (ROE) measures how much net income the company earns on shareholders' book investment. It is an accounting measure. The cost of equity is different. It is the minimum return shareholders require for bearing equity risk. If ROE is persistently above cost of equity, the firm is likely creating value for shareholders. If below, it is destroying value.
Key formulas to remember
- Book value of equity
- Book value of equity = Total assets − Total liabilities
- Accounting figure. Preferred shares are usually removed to get common equity.
- Market value of equity
- Market capitalization = Share price × Shares outstanding
- Use shares outstanding, not shares authorized.
- Book value per share
- BVPS = (Common equity) ÷ (Shares outstanding)
- Compare with the market price per share to see the market-to-book gap.
- Return on equity
- ROE = Net income ÷ Average book value of equity
- If the question gives only one equity figure, use it. With preferred shares, use net income minus preferred dividends over common equity.
- Cost of equity
- Cost of equity = Minimum required return on equity
- A market-based required return, not an accounting number. It is higher than the cost of debt because equity bears more risk.
- Value-creation test
- ROE > Cost of equity → value created; ROE < Cost of equity → value destroyed
- A rule of thumb, since ROE is based on book values.
How to solve Equity Risk and the Role of Equity in Company Financing questions
Most questions on this topic ask you to compute a figure, compare two values, or rank securities by risk. Use this routine.
- 1Read what the question asks: risk ranking, book vs market, ROE, or required return.
- 2For risk questions, rank by claim on assets and cash flows: debt senior and contractual, preferred in the middle, common last and residual. More risk means higher required return.
- 3For book value, compute assets minus liabilities. Subtract preferred equity if you need common equity.
- 4For market value, multiply price by shares outstanding. Check units and the share count.
- 5For ROE, divide net income by average book equity (or the figure given). Subtract preferred dividends first if preferred shares exist.
- 6Compare ROE with the cost of equity, or market value with book value, and state what it implies.
- 7Check the unit (ROE in %), then pick the option that matches your computed result; options are listed from smallest to largest.
Quickest way: Three-line shortcut
When to use it: Use it when the question gives clean numbers and you have about 90 seconds.
- Risk question: pick the option that ranks common equity as most risky and with the highest required return.
- Calculation: write one formula, plug in, and compute once.
- Verify the unit: ROE in %, equity in currency. Then match to the option closest to your result.
Common mistakes in Equity Risk and the Role of Equity in Company Financing
Treating ROE as the cost of equity.
Both are percentages linked to shareholders.
Fix: ROE is what the firm earned on book equity. Cost of equity is what investors require. Compare them, do not swap them.
Using total equity including preferred shares for common ROE.
Students skip the capital structure details.
Fix: Subtract preferred dividends from net income and preferred equity from the denominator for common shareholders.
Using shares authorized or issued instead of outstanding for market cap.
Several share counts appear in the stem.
Fix: Use shares outstanding, which excludes treasury shares.
Assuming book value equals market value.
Both are called value of equity.
Fix: Book value uses historical accounting. Market value reflects expected future cash flows and can be far higher or lower.
Saying equity is safer because the issuer never has to repay it.
Confusing the issuer's view with the investor's view.
Fix: No repayment obligation lowers the issuer's risk. Investors bear residual risk, so equity is riskier for them and its cost is higher.
Worked examples
Example 1
A company has total assets of $850 million and total liabilities of $610 million. It has 40 million shares outstanding trading at $9.00. What is the market value of equity minus the book value of equity?
Show the solution
- Book value of equity = 850 − 610 = $240 million.
- Market value of equity = 40 million × $9.00 = $360 million.
- Difference = 360 − 240 = $120 million.
Answer: Market value exceeds book value by $120 million.
Example 2
A firm reports net income of €18 million. Book equity was €120 million at the start of the year and €150 million at the end. Its cost of equity is 11%. Compute ROE using average equity and say whether the firm earned more than its cost of equity.
Show the solution
- Average equity = (120 + 150) ÷ 2 = €135 million.
- ROE = 18 ÷ 135 = 0.1333, or 13.33%.
- Compare: 13.33% > 11%.
Answer: ROE is 13.33%, above the 11% cost of equity, which suggests value creation.
Exam tips
- Risk questions are usually about order of claims: debt, then preferred, then common. Pick the option consistent with that order.
- When asked about market vs book value, remember that a gap reflects expectations and accounting conventions, not an error.
- Read whether ROE uses average or ending equity and follow the stem. If only one equity number is given, use it.
- With three options in ascending order, estimate first and eliminate options far from your estimate.
- Watch for preferred dividends in ROE for common shareholders.
Practice questions from Equity Instrument Features
- Compared with a company's creditors, its common shareholders are most likely to:
- A company repurchases some of its common shares and holds them rather than cancelling them. These shares are best described as:
- An investor values a stake in a privately held firm using the price of comparable listed companies. To reflect the lack of a ready market fo…
- An analyst values a privately held company using the price of comparable listed firms. Relative to the listed comparables, the private compa…
- A company has total assets with a market value of 500 million, liabilities of 320 million, and a book value of equity of 150 million. Which …
Equity Risk and the Role of Equity in Company Financing in other exams
The same ground in other exams, if you are preparing for more than one or want another angle on it.
Equity Risk and the Role of Equity in Company Financing: frequently asked questions
What is the difference between book value and market value of equity?
Book value is assets minus liabilities from the balance sheet, based largely on historical costs. Market value is share price times shares outstanding and reflects investor expectations. They rarely match.
How do you calculate ROE for the CFA exam?
ROE = net income ÷ average book value of equity. If the question gives only one equity figure, use that. For common shareholders, subtract preferred dividends from net income first.
Why is the cost of equity higher than the cost of debt?
Shareholders have a residual claim, rank last in liquidation, and receive uncertain cash flows. They need a higher expected return to compensate for that risk.
Is cost of equity the same as required return?
Yes, in this context it is the minimum return shareholders require to hold the equity. It is what the company must earn on equity-financed investments to satisfy investors.