Page 102 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes
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
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

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