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Cost of equity shares

Cost of Equity Capital

This document explains howthe toconcept calculateof the cost of equity capital, a crucialcapital and often complex aspect of a company's overall cost of capital. It explores various methods,methods used to calculate it, including the dividend yield, earningsdividend yield plus growth, earning yield, and Capitalrealized Assetyield Pricing Model (CAPM) approaches.methods.

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 toinvest compensatewith theman forexpectation of receiving dividends and capital gains that are commensurate with the level of risk they takehave byundertaken. investingFrom ina company's perspective, they must earn more than the company.cost Itof is the minimum return that a company should earn on its equity-financed investmentsequity to maintainensure itsthe market value of their shares remains stable and attractattracts investors.

2. Key Concepts

  • Cost of Equity Capital (ke):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: TheA ratio of dividendsthe paiddividend per share to the market price of theper share.
  • EarningsEarning Yield: TheA ratio of the earnings per share to the market price of theper share.
  • Capital Asset Pricing Model (CAPM): A model used to estimate the required return on equity, given its non-diversifiable risk (beta).
  • EPS: Earnings Perper Shareshare.
  • RfRf:: theThe risk-free rate.
  • KmKm:: theThe required rate of return on the market portfolio.
  • bb:: 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: EquityDespite capitalthe isabsence notof free.a Whilelegal companies are not legally obligedobligation to pay dividends, it'sequity capital is not free.
  • Opportunity Cost: Equity capital involves an implicit cost representing the opportunity cost tobecause shareholders ofinvest theirexpecting investment, and impacts market prices.
  • Shareholder Expectations: Shareholders expect returns (dividends and capital gains)gains commensuratethat withcompensate for their risk.investment risks.
  • Market Forces: The market valueprice of sharesshares, determined by demand and supply, reflects the rate of returnreturns required by shareholders.
  • External Equity costsCosts more: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: TheThis method equates the cost of equity is equal towith the present value of future dividendsdividend per share, dividedbased byon the current market price of the share.

    price.

  • Formula:

  Cost of Equity Shares = Dividend per Equity Share / Market Price
per
Share
  • 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 athe company's growth and expects shareholders to receive profits basedin online thewith company'sthat growth.
    • Formula: 
    Cost of Equity Share = (Dividend per equity/Equity / Market Price) + Rate of Growth in Dividends

4.3. Earning Yield Method

  • Concept: TheThis method considers that the cost of equity isshould be based on the earnings of the company consideredper againstshare, based on the market price per share.
    • FormulaFormula: 
    Cost of equityEquity shareShare = Earnings per share / Market Price per share

4.4. Realized Yield Method

  • Concept: This method considers theuses actual earningsearnings, perrather sharethan (EPS)future earned on the amount of investment, and is based on actual earning instead of forecasts.estimates.
  • FormulaFormula: 
Cost of Equity Share = Actual earnings per share * 100

4.

5. Earnings-Price Ratio and the Cost of Equity

5.1. Earnings Per Share (EPS)

  • EPS Calculation:Definition: Earnings per share ratio(EPS) (EPS Ratio) are calculated by dividingmeasures the netearnings profitattributed afterto taxeseach andoutstanding preference dividend by the total numbershare of equitya shares.

    company's stock.

  • Calculation: 

EPS = (Net Profit After Tax - Preference Dividend) / No.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 doesis not accuratelyan reflectaccurate measure of the cost of equity because shareholder expectations,returns asinclude they expect a stream offuture dividends and athe finalincrease price higher thanin the earningsvalue perof the share.
  • It does not account for growth.

5.4.6. Example of Earning Yield Method

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

    Calculate
  • the Costcost of Equity:equity. Ke= Rs 10 / 80= 12.5%

If the payout ratio is assumed to be 60% and the firm earnswith a 15% return on itsinvestments, investments,then what would be the cost of equity would be calculated as:equity?

    100%
  • Payout DividendRatio:

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

    60% Payout Ratio:

    Dividend per share: 10 * 0.6=6 = Rs 6

  • Expected Growth:growth rate: (1 - 0.46) x* 0.15=15 0.06
    • = 
  • 6%
Cost of equity:Equity: Ke = Rs6(6 / Rs8080) + 0.06 = 13.5%
    •

5.6. Understanding the Cost of Equity Capital: Conceptual Overview

  • Difficult to MeasureMeasure:: The cost of equity is difficulta tocomplex measureand ascontroversial unlikeaspect debt,of financial management, with multiple viewpoints on how it should be measured.
  • Not Fixed Rate: Unlike debt or preference shares, there is no legal obligation to pay dividends, and no fixed rate.dividend rate associated with equity shares.
  • Ranking in Claim: Equity holders are ranked lowest in preference in claim on the company’s assets.
  • Shareholder ExpectationsExpectations:: Equity shareholdersholders expect returns in the form of dividends and capital gainsgains, thatand are commensurate with their risk.
  • Market Value: Thethe market valueprice of a shareshares reflects the expectedrequired returnrate byof shareholders.return.
  • Highest CostCost:: The cost of equity capital is typicallygenerally thehigher highestthan among all sources of fundsdebt due to the higher risk bornetaken by equity investors.
Debt-Yield

7. Plus Risk Premium Approach: One simple approach isApproaches to addCalculating a risk premiumCost of 3-5Equity

percentage points to the interest rate paid on its long-term debt to determine the cost of equity capital.

6.

7.1. Dividend Valuation Model Approach

6.1. Concept

ThisFormula:

approach
ke 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= (orD1/P0) current+ marketg
price) of a share.


6.2. Formula
  • ConstantMultiple 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. KeyCAPM 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. FormulaApproach

KeFormula:

ke = Rf + b (Km – Rf)
Where:

8. Comparison of Methods

  • Ke =Dividend CostApproach: ofUses equityexpected capitalfuture dividends, relies on constant growth assumption.
  • Rf =CAPM Risk-freeApproach: Considers risk (beta), does not need steady growth assumptions.
  • Hybrid Approach: Adds a risk premium to the rate of return
  • Km = Required rate of returnpaid on the market portfolio (average return on all assets)
  • b = Beta coefficient (measure of systematic risk).debt.

7.4.

9. ExamplePractical Considerations

  • Multiple Estimates: Different methods may produce varying estimates 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 equityequity.

    • would
  • be:

    Judgment:

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

    7.5. Advantagesanalysis and Limitationssound judgment are essential in determining the cost of CAPM

    equity.

    • 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.

9.10. Conclusion

Calculating the cost of equity capital is a complex but essential task. UnderstandingWhile andno applying the various methods—dividend yield, earnings yield, and CAPM—is crucial for sound financial management. No onesingle method is completelyperfect, accuratecombining ormultiple bettermethods incan all cases, and it is often importantlead to assessa andmore averagecomplete the resultscalculation of these techniques to arrive at the correct cost of equity for a firm.capital.

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