Page 101 - DMGT405_FINANCIAL%20MANAGEMENT

Unit 6: Cost of Capital

of retained earnings cost, taken separately leads to double the company’s cost of capital. Assumption Notes
of earnings capitalization approach is employed under the following conditions:
1. Constant earnings per share over the future period;
2. There should be either 100 per cent rotation ratio or 100 per cent dividend payout ratio;
and
3. The company satisfies the requirements through equity shares and does not employ debt.
Cost of equity can be calculated with the following formula:
E
K =
e
CMP or NP
Where,
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

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