Page 104 - DMGT207_MANAGEMENT_OF_FINANCES

Unit 5: Cost of Capital

Bond Yield Plus Risk Premium Approach Notes

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
The logic of this approach is very simple, equity investors bear a higher risk than bond investors
and hence their required rate of return should include a premium for their higher risk. In other
words, bond holders and equity shareholders, both are providing funds to the company, but the
company assures a fixed rate of interest to the bond holders and not to the equity shareholders,
hence, there is a risk involved due to uncertainty of expected dividends. It makes a sense to base
the cost of equity on a readily observable cost of debt. The problem involved in this approach,
is the addition of premium, should it be one per cent, two per cent, three per cent or ‘n’ per cent.
There is no theoretical basis for estimating the risk premium. Most analysts look at the operating
and financial risks of the business and arrive at a subjectively determined risk premium that
normally ranges between 3 per cent to 5 per cent. Cost of equity capital calculated, based on this
approach is not a precise one, but it is a ballpark estimation.
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.

Did u know? What is Realised Yield Approach?
Realised Yield Approach 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 significantly.
Calculation of the cost of equity based on realised yield approach is not realistic, due to unrealistic
assumptions.
Illustration 12: 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
e
Illustration 13: 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

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