Page 67 - DMGT409Basic Financial Management

Basic Financial Management

Notes Bond Yield Plus Risk Premium Approach

According to this approach, the rate of return required by the equity shareholder of a company
is equal to
K = yield on long-term bonds + risk premium
e
Illustration 7: XYZ Company is planning to sell equity shares. Mr. A is planning to invest in
XYZ Company by purchasing equity shares. Bond yield of XYZ Company is 12 per cent. Mr. A,
an investor requests you to calculate his required rate of return on equity with 3 per cent risk
premium.
Solution:

K = Bond yield + risk premium = 10% + 3% = 13 per cent
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Realised Yield Approach

Computation of the cost of equity based on dividends capitalisation and earnings capitalisation,
have serious limitations. It is not possible to estimate future dividends and earnings correctly,

both these variables are uncertain. In order to remove the difficulty in the estimation of the rate
of return that investors expect on equities, where future dividends, earnings and market price of
share are uncertain, Realised Yield Approach is suggested. It takes into consideration that, the
actual average rate of returns realised in the past few years, may be applied to compute the cost
of equity share capital i.e, the average rate of returns realised by considering dividends received
in the past few years along with the gain realised at the time of sale of share.
This is more logical because the investor expects to receive in future at least what he has received
in the past. The realised yield approach is based on the following assumptions:
1. Firms risk does not change over the period.
2. Past realised yield is the base for shareholders expectations.
3. There is no opportunity cost to investors.

4. Market price of equity share does not change signifi cantly.
!

Caution Calculation of the cost of equity based on realised yield approach is not realistic,
due to unrealistic assumptions.
Illustration 8: An investor purchased equity share of HPH company at ` 240 on 01.01.1998 and
after holding it for 5 years sold the share in early 2003 at ` 300. During this period of 5 years, he
received a dividend of ` 14 in 1998 and 1999 and ` 14.5 from 2000 to 2002. Calculate the cost of
equity capital based on realised yield approach with 10 per cent discounting factor.

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