Page 100 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Where, Notes
K = Cost of equity
e
E = Earnings per share
CMP = Current market price per share

NP = Net proceeds per share.
Illustration 6: Well do Company Ltd. is currently earning 15 per cent operating profit on its
share capital of 20 lakh (FV of 200 per share). It is interested to go for expansion for which the
company requires an additional share capital of 10 lakh. Company is raising this amount by
the issue of equity shares at 10 per cent premium and the expected floatation cost is 5 per cent.
Calculate the cost of equity.
Solution:

E
K = ×100
e
NP
30
= × 100
( 200+20–10)
30
= ×100
210
= 14.3 per cent

1. Calculation of EPS
Operating Profit = 20,00,000 × 0.15 = 3,00,000
No.of Equity Shares = 20,00,000/200 = 10,000 Shares
EPS = 3,00,000/10,000 = 30
2. Net Proceeds (NP) = Face value + Premium – Floatation cost

= 200 + 20 – 10 = 210
Illustration 7: A firm is currently earning 1,00,000 and its share is selling at a market price of
90. The firm has 10,000 shares outstanding and has no debt. Compute the cost of equity.

Solution:
E
K = ×100
e
MP
10
= ×100 = 11.11
90
Limitations: Earnings capitalization approach has the following limitations:

1. All earnings are not distributed to the equity shareholders as dividends.
2. Earning per share may not be constant.
3. Share price also does not remain constant.

Dividend Capitalization Plus Growth Rate Approach [(D/MP) + g]

Computation of cost of equity capital based on a fixed dividend rate may not be appropriate,
because the future dividend may grow. The growth in dividends may be constant perpetually or

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