Page 66 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

4.75 Notes
K = + 0.06
e
100

= 0.048 + 0.06

= 10.8 per cent
Calculate cost of external equity (Issue of shares)
4.75
K = + 0.06
e 95

= 0.050 + 0.06

= 11 per cent
Cost of Capital under Variable Growth Rate

The computation cost of equity after a specific period, is based on the estimation of growth rate
in dividends of a company. Expected growth rate will be calculated based upon the past trend
in dividend. It may not be unreasonable to project the trend into the future, based on the past

trend. The financial manager must estimate the internal growth rate in dividends on the basis
of long range plans of the company. Expected growth rate in the internal context requires to be
adjusted.
Your can estimate by using the following formula:
1. Average Annual Growth Rate: The following group to explain the calculation by using
Average Annual Growth Rate method.

Example:
Year Div. per share Rupee charge Growth
1996 21 ---- ----
1997 22 1 4.76
1998 23 1 4.55
1999 24 1 4.35
2000 25 1 4.17
2001 26 1 4.00
2002 27 1 3.85
2003 28 1 3.70

If you average the 7 growth rates, the result will be 4.19%. So you can use this as an estimate
of the expected growth rate g.
2. Return of Growth Rate Method: In this method you first forecast the fi rm’s average

retention rate and then multiply it by the firm’s expected future return on equity (ROE)

g = (Retention Rate) × (ROE)
where
Retention Rate = 1- Div. Payout Rate

Example: If the forecasted retention rate and return on equity are 0.60 and 15% respectively,
the growth rate is:
g = (0.60) (15%) = 9 %

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