Page 64 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

Earnings Capitalisation Approach (E/MP Approach)/Earning Price ratio Approach Notes

According to this approach, the cost of equity (K ) is the discount rate that equates the present
e
value of expected future earnings per share with the net proceeds (or current market price) of a
share.
Assumption of earnings capitalization approach is employed under the following conditions:
(a) Constant earnings per share over the future period;

(b) There should be either 100 per cent rotation ratio or 100 per cent dividend pay out ratio
and,

(c) The company satisfies the requirements through equity shares and does not employ debt.
Cost of equity can be calculated with the following formula:

E
K =
e
CMP or NP
Where,
K = Cost of equity
e
E = Earnings per share

CMP = Current market price per share
NP = Net proceeds per share

Illustration 4: Well do company Ltd. is currently earning 15 per cent operating profit on its
share capital of ` 20 lakh (FV of ` 200 per share). It is interested to go for expansion for which the
company requires an additional share capital of ` 10 lakh. Company is raising this amount by
the issue of equity shares at 10 per cent premium and the expected floatation cost is 5 per cent.

Calculate the cost of equity.
Solution:
E
K = × 100
e NP
` 30
= × 100
( 200 20 10+` − )
` 30
= × 100
` 210
= 14.3 per cent
1. Calculation of EPS
Operating Profi t = `20,00,000 x 0.15 = `3,00,000

No.of Equity Shares = 20,00,000/200 = 10,000 Shares
EPS = 3,00,000/10,000 = `30
2. Net Proceeds (NP) = Face value + Premium – Floatation cost = 200 +20 – 10 = `210
Illustration 5: A firm is currently earning ` 1,00,000 and its share is selling at a market price of

` 90. The firm has 10,000 shares outstanding and has no debt. Compute the cost of equity.

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