Cost of equity shares

Cost of Equity Capital

This document explains how to calculate the cost of equity capital, a crucial and often complex aspect of a company's overall cost of capital. It explores various methods, including the dividend yield, earnings yield, and Capital Asset Pricing Model (CAPM) approaches.

1. Introduction

The cost of equity capital is the return that a company must provide to its equity shareholders to compensate them for the risk they take by investing in the company. It is the minimum return that a company should earn on its equity-financed investments to maintain its market value and attract investors.

2. Key Concepts

Cost of Equity Capital (ke): 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: The ratio of dividends paid per share to the market price of the share.

Earnings Yield: The ratio of earnings per share to the market price of the share.

Capital Asset Pricing Model (CAPM): A model used to estimate the required return on equity, given its non-diversifiable risk (beta).

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: Equity capital is not free. While companies are not legally obliged to pay dividends, it's an implicit cost representing the opportunity cost to shareholders of their investment, and impacts market prices.

Shareholder Expectations: Shareholders expect returns (dividends and capital gains) commensurate with their risk. The market value of shares reflects the rate of return 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

4.1. Dividend Yield Method (Price Ratio Method)

Concept: The cost of equity is equal to the present value of future dividends per share, divided by the current market price of the share.

Formula:

  Cost of Equity Shares =  Dividend per Equity Share / Market Price per Share

4.2. Dividend Yield Plus Growth in Dividend Method

Concept: This method considers a company's growth and expects shareholders to receive profits based on the company's growth.
- Formula:
```
Cost of Equity Share = (Dividend per equity/Market Price) + Rate of Growth in Dividends
```

4.3. Earning Yield Method

Concept: The cost of equity is the earnings of the company considered against 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 considers the actual earnings per share (EPS) earned on the amount of investment, and is based on actual earning instead of forecasts.

Formula

Cost of Equity Share = Actual earnings per share * 100

4.5. Earnings-Price Ratio and the Cost of Equity

EPS Calculation: Earnings per share ratio (EPS Ratio) are calculated by dividing the net profit after taxes and preference dividend by the total number of equity shares.

EPS = (Net Profit After Tax - Preference Dividend) / No. of Equity Shares

Limitations: The E/P ratio does not accurately reflect shareholder expectations, as they expect a stream of dividends and a final price higher than the earnings per share. It does not account for growth.

4.6. Example of Earning Yield Method

A firm is currently earning Rs. 100,000, and its share is selling at a market price of Rs. 80. The firm has 10,000 shares outstanding and no debt. The earnings are expected to remain stable, and it has a payout ratio of 100%.

Cost of Equity: Ke= Rs 10 / 80= 12.5%

If the payout ratio is assumed to be 60% and the firm earns a 15% return on its investments, the cost of equity would be calculated as:

5. Cost of Equity Capital: Conceptual Overview

Difficult to Measure: The cost of equity is difficult to measure as unlike debt, there is no legal obligation to pay dividends, and no fixed rate.

Shareholder Expectations: Equity shareholders expect returns in the form of dividends and capital gains that are commensurate with their risk.

Market Value: The market value of a share reflects the expected return by shareholders.

Highest Cost: The cost of equity capital is typically the highest among all sources of funds due to the higher risk borne by equity investors.

Debt-Yield Plus Risk Premium Approach: One simple approach is to add a risk premium of 3-5 percentage points to the interest rate paid on its long-term debt to determine the cost of equity capital.

6. Dividend Valuation Model Approach

6.1. Concept

This approach defines the cost of equity as the discount rate that equates the present value of all expected future dividends per share to the net proceeds of the sale (or current market price) of a share.

6.2. Formula

Constant Growth Model: Assuming dividends grow at a constant rate (g):

P0 = D1/(ke-g) OR ke = D1 / P0 + g

Where:

ke = Cost of equity capital * D1 = Expected dividend per share * P0 = Net proceeds per share (or current market price) * g = Growth rate in expected dividends

Multiple Growth Model: Where dividends grow at different rates over time. This is calculated using the following formula:

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

P0 = Net Proceeds of shares

Dt = Dividend payments over period t

Pn = Value at the end of the period n

ke = Cost of equity

6.3. Limitations of Dividend Growth Model

Applicability: Only applicable to companies that pay regular dividends.

Sensitivity to Growth Estimates: The cost of equity is highly sensitive to the estimated growth rate, which is often difficult to predict accurately.

Risk Factor: The approach does not explicitly consider risk.

6.4. Example of Dividend Growth Model

A firm is expected to pay a dividend of Re 1 per share next year, and this is expected to grow at 6% perpetually.

Cost of Equity: Ke= 1 / 25 + 0.06 = 10%

7. Capital Asset Pricing Model (CAPM) Approach

7.1. Concept CAPM explains the relationship between risk and expected returns and provides a mechanism for investors to evaluate investments based on their risk-return trade-off. It calculates cost of equity based on the systematic (market) risk.

7.2. Key Assumptions

Efficient Markets:

Homogeneous expectations among investors about returns, variance, and correlation.

Equal access to information.

No investment restrictions.

No taxes or transaction costs.

No single investor can affect market price.

Investor Preferences: Investors are risk-averse, preferring the highest return for a given risk level.

7.3. Formula

Ke = Rf + b (Km – Rf) Where:

Ke = Cost of equity capital

Rf = Risk-free rate of return

Km = Required rate of return on the market portfolio (average return on all assets)

b = Beta coefficient (measure of systematic risk).

7.4. Example of CAPM Approach

Given a risk-free rate of return of 10%, a firm’s beta of 1.5, and market portfolio return of 12.5%, the cost of equity would be:

ke = 10% + 1.5(12.5% - 10%) = 13.75%

7.5. Advantages and Limitations of CAPM

Risk Consideration: Directly considers risk as reflected in beta.

Applicability: Suitable for companies not paying dividends or with irregular growth.

Practical problems:

Difficult to find data for expected returns and to get appropriate estimates for beta and risk free rates.

Only considers systematic risk and not total risk which poorly diversified investors may be more interested in.

8. Choosing a Method

Both the dividend model and CAPM approach are theoretically sound.

Each method relies on different assumptions and may lead to different estimates.

Assess each estimate for reasonableness and, or average the various estimates of ke.

9. Conclusion

Calculating the cost of equity capital is a complex but essential task. Understanding and applying the various methods—dividend yield, earnings yield, and CAPM—is crucial for sound financial management. No one method is completely accurate or better in all cases, and it is often important to assess and average the results of these techniques to arrive at the correct cost of equity for a firm.