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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