Page 65 - DMGT409Basic Financial Management

Basic Financial Management

Notes Solution:

E
K = × 100
e MP
` 10
= × 100 = 11.11
90
Dividend Capitalization plus Growth Rate Approach [(D/MP) + g]/ Dividend Growth
Model Approach

Computation of cost of equity capital based on a fixed dividend rate may not be appropriate,
because the future dividend may grow. The growth in dividends may be constant perpetually or
may vary over a period of time. It is the best method over dividend capitalisation approach, since
it considers the growth in dividends. Generally, investors invest in equity shares on the basis of
the expected future dividends rather than on current dividends. They expect increase in future
dividends. Growth in dividends will have positive impact on share prices.
Cost of Capital under Constant Growth Rate Perpetually

The formula for computation of cost of equity under constant growth rate is:
D
K = + g
e NP or CMP
Where,
K = Cost of equity capital.
e
D = Dividends per share.
NP = Net proceeds per share.
CMP = Current market price per share.
g = Growth rate (%).

Dividend per share is the expected dividend per share and if dividend for the last year is given
then the expected dividend will be calculated as:
D = D (1+g)
1 0
Where

D = value of expected divided
1
D = value of dividend paid for last year
0
G = growth rate
In the above case if the formula to calculate the cost of equity will be:
= D (1+g)/NP or CMP + g
0
Illustration 6: Equity shares of a paper manufacturing company is currently selling for ` 100. It
wants to finance its capital expenditure of ` 1 lakh either by retaining earnings or selling new

shares. If company seeks to sell shares, the issue price will be ` 95. The expected dividend next
year is ` 4.75 and it is expected to grow at 6 per cent perpetually. Calculate cost of equity capital
(internal and external).

Solution:
D
K = + g
e MP

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