Page 99 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Illustration 5: XYZ Ltd., is currently earning 1,00,000, its current share market price of 100
outstanding equity shares is 10,000. The company decides to raise an additional capital of
2,50,000 through issue of equity shares to the public. It is expected to pay 10 per cent per share
as floatation cost. Equity capital is issued at a discount rate of 10 per cent, per share. The company
is interested to pay a dividend of 8 per share. Calculate the cost of equity.
Solution:

D
K = ×100
e
NP
8
e K = ×100
 100–10–10 
8
K = ×100
e
80
= 10 per cent

Notes Dividend capitalization approach, suffers from the following limitations:
1. It does not consider future earnings.

2. It ignores the earnings on retained earnings.
3. It ignores the fact that market price raise may be due to retained earnings and not on
account of high dividends.

4. It does not take into account the capital gains.

Earnings Capitalisation Approach (E/MP Approach)

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. The advocates of this approach establish a relationship between earnings and market
price of the share. They say that, it is more useful than the dividend capitalisation approach, due
to two reasons, one, the earnings capitalization approach acknowledges that all earnings of the
company, after payment of fixed dividend to preference shareholders, legally belong to equity
shareholders whether they are paid as dividends or retained for investment, secondly, and most
importantly, determining the market price of equity shares is based on earnings and not dividends.
Computation of retained earnings cost, taken separately leads to double the company’s cost of
capital. Assumption of earnings capitalization approach is employed under the following
conditions:
1. Constant earnings per share over the future period;
2. There should be either 100 per cent rotation ratio or 100 per cent dividend pay out ratio;
and
3. 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

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