Cost of Equity Share Capital

Cost of Equity Share Capital:

It is that part of cost of capital that is payable to equity shareholder. Each and every shareholder acquires shares for getting return on it. Therefore, for company view point, it will be cost and company should earn more than cost of equity capital in order to depart unaffected market value of its shares.

We can compute cost of equity capital with following manner:

A. Dividend yield technique or Dividend Price ratio technique:

According to dividend yield technique or dividend price ratio technique, “Cost of equity capital is minimum rate that will be equivalent to the present value of future dividend per share with present price of a share.

Cost of equity = Dividend per equity share/ Market price or net proceed of per share
Ke = DPS/ MPPS or NPPS

A company issues 1000 shares of $ 100 each at a premium of 10%. The company has been paying 20 percent dividend to equity shareholders for the past 5 years and expects to maintain similar in the future as well. Calculate the cost of equity capital. Will it make any difference when the market price of equity share is $160?

Answer:

Ke= DPS/MPPS or NPPS
= 20/110 X 100
= 18.18%
When the market price of equity share is $160.
=20/160 X 100 = 12.5%
At rising of market price, the value of cost of equity capital will reduce.

B. Dividend yield plus growth in dividend technique:

This technique is based on the supposition that company is rising and its shares market value is as well increasing. In that condition, shareholders want more than simple dividend, therefore company can give some more gain according to growth. Therefore, we will add it in previous computed cost of equity capital.

Cost of Equity Capital = DPS/ MPPS or NPPS + Rate of growth in dividends
Ke = DPS/ MPPS or NPPS + G%

The company plans to issue 1000 new equity shares of $100 each at par. The floatation costs are predicted to be 5 percent of the share price. The company pays a dividend of $10 per share initially and the expansion in dividends is expected to be 5 percent. Calculate the cost of new issue of equity shares.

= 10/100-5 + 5% = 15.53%

When the current market price of equity share is $150, compute the cost of existing equity share capital.

=10/150 +5% = 11.67%

C. Earning yield technique:

According to this technique, cost of equity capital is least rate that we have to earn on market price of a share. Its formula is:

Ke = Earnings per share / Net proceed or Market price per share
Ke = EPS/ MPPS or NPPS

The firm is considering expenses of Rs. 60 lakhs for expanding its operations. The related information is as shown below:

Number of existing equity shares = 10 Lakhs
Market value of existing share = Rs. 60
Net Earning = Rs. 90 Lakh

Calculate the cost of existing equity share capital and of new equity capital supposing that new shares will be issued at price of Rs. 52 per share and costs of new issue will be Rs. 2 per share.

Earnings per share = earning / total number of shares = 90/10
= Rs. 9
Ke = 9/60 X 100
Ke = 15%
Cost of new equity capital:
Ke = 9/52-2 X 100 = 18%

D. Realized yield technique:

One of main limitation of dividend yield technique or earning yield technique which both techniques are based on estimation of future dividend or earning. There are big numbers of factors that are uncontrollable and uncertain. And when any financial risk will occur, we cannot utilize it in future planning or we too can’t take any decision associated to estimation of return on investment. Therefore, realized yield technique is best technique for computing the cost of equity share capital.

This technique is based on real earning earned on all amount of investment. Subsequent to this, we try to know, how much money is financed from equity share capital and reserve amount of precedent profits and subsequent to this we compute cost of equity share capital.

Ke = Actual earnings per Share/Market price per share X 100

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