Page 106 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 3. There is no opportunity cost to investors.

4. Market price of equity share does not change significantly.
Calculation of the cost of equity based on realised yield approach is not realistic, due to unrealistic
assumptions.

Illustration 12:
XYZ Company is planning to sell equity shares. Mr. A is planning to invest in XYZ Company by
purchasing equity shares. Bond yield of XYZ Company is 12 per cent. Mr. A, an investor requests
you to calculate his required rate of return on equity with 3 per cent risk premium.
Solution:
K = Bond yield + Risk premium = 10% + 3% = 13 per cent
e
Illustration 13:
An investor purchased equity share of HPH company at 240 on 01.01.1998 and after holding it
for 5 years sold the share in early 2003 at 300. During this period of 5 years, he received a
dividend of 14 in 1998 and 1999 and 14.5 from 2000 to 2002. Calculate the cost of equity capital
based on realised yield approach with 10 per cent discounting factor.
Solution:
Years Cash inflows ( ) DF 10% PV of Cash inflows ( )
1998 14.0 0.909 12.7
1999 14.0 0.826 11.6
2000 14.5 0.751 10.9
2001 14.5 0.683 9.9
2002 14.5 0.621 9.0
2003 300.0 0.621 186.3
240.4
(-) Purchase price in 1998 240.0
0.4
At 10 per cent discount rate, the total PV of cash inflows equals to the PV of cash outflows. Hence,
cost of equity capital is 10 per cent.

6.4.2 Cost of Preference Shares

The preference share is issued by companies to raise funds from investors. Preference share has
two preferential rights over equity shares, (i) preference in payment of dividend, from
distributable profits, (ii) preference in the payment of capital at the time of liquidation of the
company.

Computation of cost of preference share capital have some conceptual difficulty. Payment of
dividend is not legally binding on the company and even if dividends are paid, they are not a
charge on earnings, they are distributed from distributable profits. This may create an idea that
preference share capital is cost free, which is not true.
The cost of preference share capital is a function of the dividend expected by the investors.
Generally, preference share capital is issued with an intention (a fixed rate) to pay dividends. In
case dividends are not paid, it will affect the firm’s fund raising capacity. For this reason,
dividends on preference share capital should be paid regularly except when the firm does not
make profits.

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