Page 100 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes 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.
Illustration 5:

XYZ Ltd., is currently earning 1,00,000, its current share market price of 100 outstanding
equity shares is 10,000. The company decides to raise an additional capital of 2,50,000 through
issue of equity shares to the public. It is expected to pay 10 per cent per share as floatation cost.
Equity capital is issued at a discount rate of 10 per cent, per share. The company is interested to
pay a dividend of 8 per share. Calculate the cost of equity.
Solution:

D
K = ×100
e NP
8
K = × 100
e 100 – 10 – 10 
8
K = × 100
e 80
= 10 per cent

Notes Dividend capitalization approach, suffers from the following limitations:

1. It does not consider future earnings.
2. It ignores the earnings on retained earnings.
3. It ignores the fact that market price raise may be due to retained earnings and not on
account of high dividends.
4. It does not take into account the capital gains.

Earnings Capitalisation Approach (E/MP Approach)
According to this approach, the cost of equity (K ) is the discount rate that equates the present value
e
of expected future earnings per share with the net proceeds (or current market price) of a share. The
advocates of this approach establish a relationship between earnings and market price of the
share. They say that, it is more useful than the dividend capitalisation approach, due to two
reasons, one, the earnings capitalization approach acknowledges that all earnings of the company,
after payment of fixed dividend to preference shareholders, legally belong to equity shareholders
whether they are paid as dividends or retained for investment, secondly, and most importantly,
determining the market price of equity shares is based on earnings and not dividends. Computation

94 LOVELY PROFESSIONAL UNIVERSITY