Page 98 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Illustration 4: BPL company’s equity share is currently being sold at 350.75 and it is currently Notes
paying a dividend of 5.25 per share. The dividend is expected to grow at 15 per cent per annum
for one year. Income tax rate is 40 per cent and brokerage is 2 per cent. Calculate cost of retained
earnings.
Solution:

 D 1 – T  
K =  + g  i  100
re
 NP 1 – T b  
 5.25 1 – 0.40 
=  + 0.15    100
 350.75 1 – 0.02 
= [ 0.165 0.613 ] 100 = 10.2 per cent

Cost of Issue of Equity Shares (K )
e
Calculation of cost of equity (K ) capital cost brings forth, a host of problems. It is the most
e
difficult and controversial cost to measure because there is no one common basis for computation.
For calculation of cost of debt (K ) interest charge is the base and preference dividend is the base
d
for calculation of cost of preference shares (K ). Interest on debentures/debt and dividend on
p
preference shares is fixed in terms of the stipulations following the issue of such debentures and
shares. In contrast, the return on equity shareholders solely depends upon the discretion of the
company management. Apart from this, there is no stipulation for payment of dividend to
equity shareholders. They are ranked at the bottom as claimants on the assets of the company at
the time of liquidation. Though it is quite evident from the above discussion that, equity capital
does not carry any cost. However, this is not true, equity capital has some cost.

The cost of equity capital (K ), may be defined as the minimum rate of returns that a firm must
e
earn on the equity financed portions of an investment project in order to leave unchanged the
market price of the shares. The cost of equity is not the out-of-pocket cost of using equity capital
as the equity shareholders are not paid dividend at a fixed rate every year.

There are some approaches available to calculate the cost of equity capital, they are:
Dividends Capitalisation Approach (D/MN Approach)

According to this approach, the cost of equity capital is calculated on the basis of a required rate
of return in terms of the future dividends to be paid on the shares. Accordingly, K is defined as
e
the discount rate that equates the present value of all expected future dividends per share, along
with the net proceeds of the sale (or the current market price) of a share. It means investor
arrives at a market price for a share by capitalizing dividends at a normal rate of return. The cost
of equity capital can be measured by the given formula:
K = D/CMP or NP
e
Where,
K = Cost of equity
e
D = Dividends per share
CMP = Current market price per share
NP = Net proceed per share

This method assumes that investor give prime importance to dividends and risk in the firm
remains unchanged and it does not consider the growth in dividend.

LOVELY PROFESSIONAL UNIVERSITY 93