Page 63 - DMGT409Basic Financial Management

Basic Financial Management

Notes
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Caution The cost of equity capital (K ), may be defined as the minimum rate of returns

e

that a firm must earn on the equity financed portions of an investment project in order to

leave unchanged the market price of the shares. The cost of equity is not the out-of-pocket
cost of using equity capital as the equity shareholders are not paid dividend at a fi xed rate
every year.
Approaches to Calculate the Cost of Equity (K )
e
There are six approaches available to calculate the cost of equity capital, they are:

Dividends Capitalisation Approach (D/MP Approach)

According to this approach, the cost of equity capital is calculated on the basis of a required rate
of return in terms of the future dividends to be paid on the shares. Accordingly, K is defi ned
e
as the discount rate that equates the present value of all expected future dividends per share,
along with the net proceeds of the sale (or the current market price) of a share. It means investor
arrives at a market price for a share by capitalizing dividends at a normal rate of return. The cost
of equity capital can be measured by the given formula:
K = D/CMP or NP
e
Where,
K = cost of equity
e
D = Dividends per share
CMP = Current market price per share

NP = Net proceed per share

Note 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 3: 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
Rs .8
K = × 100
e (100 10 10− − )

Rs .8
K = × 100
e 80
= 10 per cent

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