Page 98 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Where,

K = Cost of equity capital [D ÷ P or E/P + g].
e
T = Marginal tax rate applicable to the individuals concerned.
i
T = Cost of purchase of new securities/broker.
b
D = Expected dividend per share.
NP = Net proceeds of equity share/market price.
g = Growth rate in (%).
Illustration 1:
A company paid a dividend of 2 per share, market price per share is 20, income tax rate is 60
per cent and brokerage is expected to be 2 per cent. Compute the cost of retained earnings.
Solution:

)
æ D (1– T ö
K = ç ´ i ÷ ´ 100
re NP
è (1– T b )ø
)
æ 2 (1– 0.60 ö
= ç ´ ÷ ´ 100
è 20 (1– 0.02 )ø
= 0.10 × 0.409 × 100 = 4.1 per cent
Illustration 2:

ABC company’s cost of equity (Ke) capital is 14 per cent, the average tax rate of individual
shareholders is 40 per cent and it is expected that 2 per cent is brokerage cost that shareholders
will have to pay while investing their dividends in alternative securities. What is the cost of
retained earnings?
Solution:

)
æ (1– T ö
K = ç K ´ i ÷ ´ 100
re e
è (1– T b )ø
(1- 0.4 )
= 0.14× ×100
(1- 0.02 )
= (0.14 × 0.613) × 100 = 8.6 per cent
Illustration 3:
Life Style Garment Manufacturing Company has net earnings of 20 lakhs and all of its
stockholders are in the bracket of 50 per cent. The management estimates that under the present
conditions, the stockholder’s required rate of returns is 12 per cent. 3 per cent is the expected
brokerage to be paid if stockholders want to invest in alternative securities. Compute the cost of
retained earnings.

Solution:
)
æ (1– T ö
K = K e ç i ´ 100
re ÷
è (1– T b )ø

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