The following are some of the appropriate according to
which the cost of equity capital can be worked out:
1. Dividend price (D/P) approach
According to this approach, the investor arrives at the
market price of an equity shares by capitalizing the set
of expected dividend payments. Cost of equity capital
has therefore been defined as "the discount rate that
equates the present value of all expected future
dividends per share with the net proceeds of the sale (or
the current market price) of a share".
In other words, the cost of equity capital will be that
rate of expected dividends which will maintain the
present market price of equity shares.
This approach rightly emphasizes the importance of
dividends, but it ignores the fact that the retained
earnings have also an impact on the market price of the

29
equity shares. The approach therefore does not seem to
be very logical.
Illustration 5
: A company offers for public subscription
equity shares of Rs.10 each at a premium of 10%. The
company pays 5% of the issue price as underwriting
commission. The rate of dividend expected by the
equity shareholders is 20%.
You are required to calculate the cost of equity capital.
Will your cost of capital be different if it is to be
calculated on the present market value of the equity
shares, which is Rs.15?
Solution:
The cost of new equity can be determined according to
the following formula:
D
Ke =
NP
where
Ke
= Cost of equity capital;
D
= Dividend per equity share;
NP = Net proceeds of an equity share,
2
Ke
=
10.45
=
0.19 or 19%
Rs. 11 - Re. 0.55.
In case of existing equity shares, it will be appropriate

30
to calculate the cost of equity on the basis of market
price of the company's shares. In the present case, it can
be calculated according to the following formula:
D
Ke
=
MP
where
Ke
= Cost of equity capital;
D
= Dividend per equity share;
MP = Market price of an equity share.
2
Ke
=
15
=0.133 or 13.3%.
2. Dividend price plus growth (D/P + g) approach
According to this approach, the cost of equity capital is
determined on the basis on the expected dividend rate
plus the rate of growth in dividend. The rate of growth
in dividend is determined on the basis of the amount of
dividends paid by the company for the last few years.
The computation of cost of capital according to this
approach can be done by using the following formula:
D
+
g
Ke
=
NP
where
Ke = Cost of equity capital;
D
= Expected dividend per share;
NP = Net proceeds of per share;
g
= Growth in expected dividend.

31
It may be noted that in case of existing equity shares,
the cost of equity capital can also be determined by
using the above formula. However, the market price
(MP) should be used in place of net proceeds (NP) of
the shares as given above.
Illustration 6
: The current market price of an equity
share of a company is Rs.90. The current dividend per
share is Rs.4.50. In case the dividends are expected to
grow at the rate of 7% , calculate the cost of equity
capital.

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- Fall '16
- anonymous
- Finance, Corporate Finance, Cost Of Capital