Page 101 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes may vary over a period of time. It is the best method over dividend capitalisation approach,
since it considers the growth in dividends. Generally, investors invest in equity shares on the
basis of the expected future dividends rather than on current dividends. They expect increase in
future dividends. Growth in dividends will have positive impact on share prices.
Cost of Capital under Constant Growth Rate Perpetually

The formula for computation of cost of equity under constant growth rate is:
D
K = +g
e
NP or CMP
Where,
K = Cost of equity capital
e
D = Dividends per share.
NP = Net proceeds per share.
CMP = Current market price per share.

g = Growth rate (%).
Illustration 8: Equity shares of a paper manufacturing company is currently selling for 100. It
wants to finance its capital expenditure of 1 lakh either by retaining earnings or selling new
shares. If company seeks to sell shares, the issue price will be 95. The expected dividend next
year is 4.75 and it is expected to grow at 6 per cent perpetually. Calculate cost of equity capital
(internal and external).
Solution:
D
K = +g
e
MP
4.75
K = + 0.06
e
100
= 0.048 + 0.06 = 10.8 per cent
Calculate cost of external equity (Issue of shares)
4.75
K = + 0.06
e
95
= 0.050 + 0.06 = 11 per cent
Cost of Capital under Variable Growth Rate
The computation cost of equity after a specific period, is based on the estimation of growth rate
in dividends of a company. Expected growth rate will be calculated based upon the past trend in
dividend. It may not be unreasonable to project the trend into the future, based on the past trend.
The financial manager must estimate the internal growth rate in dividends on the basis of long
range plans of the company. Expected growth rate in the internal context requires to be adjusted.
Compound growth rate in dividends can be computed with the following formula.
n
gr = D (1 + r) = D
o n
Where,
gr = Growth rate in dividends.

D = First year dividend payment.
o

96 LOVELY PROFESSIONAL UNIVERSITY