Page 97 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes  1– T  
K = K  i   100
re e 
  1– T b
Where,
K = Cost of equity capital [D ÷ NP or E/P + g].
e
T = Marginal tax rate applicable to the individuals concerned.
i
T = Cost of purchase of new securities/broker.
b
D = Expected dividend per share.

NP = Net proceeds of equity share/market price.
g = Growth rate in (%).
Illustration 1: A company paid a dividend of 2 per share, market price per share is 20, income
tax rate is 60 per cent and brokerage is expected to be 2 per cent. Compute the cost of retained
earnings.
Solution:

 D 1 – T  
K =   i   100
re  NP 1 – T b 
 2 1 – 0.60  
=      100
 20 1 – 0.02  
= 0.10 × 0.409 × 100 = 4.1 per cent

Illustration 2: ABC company’s cost of equity (K ) capital is 14 per cent, the average tax rate of
e
individual shareholders is 40 per cent and it is expected that 2 per cent is brokerage cost that
shareholders will have to pay while investing their dividends in alternative securities. What is
the cost of retained earnings?
Solution:

 1 – T  
K =  K  i   100
re  e 1 – T  
 b 
1 - 0.4 
= 0.14× ×100
1 - 0.02 
= (0.14 × 0.613) × 100 = 8.6 per cent
Illustration 3: Life Style Garment Manufacturing Company has net earnings of 20 lakhs and all
of its stockholders are in the bracket of 50 per cent. The management estimates that under the
present conditions, the stockholder’s required rate of returns is 12 per cent. 3 per cent is the
expected brokerage to be paid if stockholders want to invest in alternative securities. Compute
the cost of retained earnings.

Solution:
  1 – T i  
K = K    100
re e   
 1 – T b 
 1 – 0.50  
=  0.10     100

 1 – 0.03  
= (0.10 × 0.516) × 100 = 5.2 per cent

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