Cost of equity shares

1. Introduction

The cost of equity capital is the return that a company must provide to its equity shareholders. It is a critical factor in determining the overall cost of capital and making investment decisions. Equity shareholders invest with an expectation of receiving dividends and capital gains that are commensurate with the level of risk they have undertaken. From a company's perspective, they must earn more than the cost of equity to ensure the market value of their shares remains stable and attracts investors.

2. Key Concepts

• Cost of Equity Capital: The return expected by equity shareholders, which reflects the company's risk profile and growth prospects.
• Internal Equity: Funds raised by retaining earnings within the company, rather than distributing them as dividends.
• External Equity: Funds raised by issuing new shares to investors.
• Dividend Yield: A ratio of the dividend per share to the market price per share.
• Earning Yield: A ratio of the earnings per share to the market price per share.
• EPS: Earnings per share.
• Rf: The risk-free rate.
• Km: The required rate of return on the market portfolio.
• b: Beta coefficient.
• Diversifiable/Unsystematic Risk: Firm-specific risk that can be minimized through diversification.
• Non-Diversifiable/Systematic Risk: Market-related risk that cannot be eliminated by diversification.

3. Is Equity Capital Free of Cost?

• Not Free: Despite the absence of a legal obligation to pay dividends, equity capital is not free.
• Opportunity Cost: Equity capital involves an opportunity cost because shareholders invest expecting dividends and capital gains that compensate for their investment risks.
• Market Forces: The market price of shares, determined by demand and supply, reflects the returns required by shareholders.
• External Equity Costs More: The cost of external equity would be more than the shareholder's required rate of return due to the cost of issuance of shares.

4. Methods to Compute the Cost of Equity Capital

4.1. Dividend Yield Method (Price Ratio Method)

• Concept: This method equates the cost of equity with the present value of future dividend per share, based on the current market price.
• Formula:

Cost of Equity Shares = Dividend per Equity / Market Price

• Example: A company issues shares of Rs 200 at a 10% premium (issue price is Rs 210) and pays a 20% dividend. The cost of equity will be:

Cost of equity = 20 / 210 = 9.52%

If the market price were Rs 260, the cost of equity would be:

Cost of equity = 20 / 260 = 7.69%

4.2. Dividend Yield Plus Growth in Dividend Method

• Concept: This method considers the company's growth and expects shareholders to receive profits in line with that growth.
• Formula:

Cost of Equity Share = (Dividend per Equity / Market Price) + Rate of Growth in Dividends

4.3. Earning Yield Method

• Concept: This method considers that the cost of equity should be based on the earnings of the company per share, based on the market price per share.
• Formula:

Cost of Equity Share = Earnings per share / Market Price per share

4.4. Realized Yield Method

• Concept: This method uses actual earnings, rather than future estimates.
• Formula:

Cost of Equity Share = Actual earnings per share * 100

5. Earnings-Price Ratio and the Cost of Equity

5.1. Earnings Per Share (EPS)

• Definition: Earnings per share (EPS) measures the earnings attributed to each outstanding share of a company's stock.
• Calculation:

EPS = (Net Profit After Tax - Preference Dividend) / Number of Equity Shares

5.2. Earnings-Price Ratio

• Definition: Ratio between a company's earnings per share and market price per share.
• Formula:

EPS Ratio = Earnings Per Share / Market Price Per Share

5.3. Limitations

• The E/P ratio is not an accurate measure of the cost of equity because shareholder returns include future dividends and the increase in the value of the share.
• It does not account for growth.

5.4. Example

A firm is currently earning Rs 100,000, and its share is selling at Rs 80. It has 10,000 outstanding shares and no debt, with a payout ratio of 100%. Calculate the cost of equity. If the payout ratio is 60% with a 15% return on investments, then what would be the cost of equity?

100% Payout Ratio:

Earnings per share: 100,000 / 10,000 = Rs 10
Cost of Equity: 10 / 80 = 12.5%

60% Payout Ratio:

Dividend per share: 10 * 0.6 = Rs 6
Expected growth rate: (1 - 0.6) * 0.15 = 6%
Cost of Equity: (6 / 80) + 0.06 = 13.5%

6. Understanding the Cost of Equity

• Difficult to Measure: The cost of equity is a complex and controversial aspect of financial management, with multiple viewpoints on how it should be measured.
• Not Fixed Rate: Unlike debt or preference shares, there is no fixed dividend rate associated with equity shares.
• Ranking in Claim: Equity holders are ranked lowest in preference in claim on the company’s assets.
• Shareholder Expectations: Equity holders expect returns in the form of dividends and capital gains, and the market price of shares reflects the required rate of return.
• Highest Cost: The cost of equity capital is generally higher than debt due to the higher risk taken by equity investors.

7. Approaches to Calculating Cost of Equity

7.1. Dividend Approach

Formula:

ke = (D1/P0) + g

• Multiple Growth Model:

P0 = ∑ [ Dt/(1+ke)^t ] + [ Pn /(1+ke)^n]

7.2. CAPM Approach

Formula:

ke = Rf + b (Km – Rf)

8. Comparison of Methods

• Dividend Approach: Uses expected future dividends, relies on constant growth assumption.
• CAPM Approach: Considers risk (beta), does not need steady growth assumptions.
• Hybrid Approach: Adds a risk premium to the rate paid on debt.

9. Practical Considerations

• Multiple Estimates: Different methods may produce varying estimates of the cost of equity.
• Judgment: Careful analysis and sound judgment are essential in determining the cost of equity.

10. Conclusion

Calculating the cost of equity is a complex but essential task. While no single method is perfect, combining multiple methods can lead to a more complete calculation of the cost of equity capital.