Cost
of Equity
Cost
of equity capital is the cost of the estimated stream of net capital outlays
desired
from equity sources” E.W. Walker.
James
C. Van Horne defines the cost of equity capital can be thought of as the rate
of discount that equates the present value of all expected future dividends per
share,
as perceived by
investors. The cost of equity is the return a company requires to decide if an
investment meets capital return requirements. Firms often use it as a capital
budgeting threshold for the required rate of return. A firm's cost of equity
represents the compensation the market demands in exchange for owning the asset
and bearing the risk of ownership. The traditional formula for the cost of
equity is the dividend capitalization model and the capital asset pricing model
(CAPM).
Opportunity Cost ?
It is sometimes argued that
the equity capital is free of cost. The reason for such argument is that it is
not legally binding for firms to pay dividends to ordinary shareholders. Further, unlike the interest
rate or preference dividend rate, the equity dividend rate is not fixed. It is
fallacious to assume equity capital to be free of cost. Equity capital involves
an opportunity cost. Ordinary shareholders supply funds to the firm in the
expectation of dividends and capital gains commensurate with their risk of
investment. The market value of the shares, determined by the demand and supply
forces in a well functioning capital market, reflects the return required by
ordinary shareholders. Thus, the shareholders’ required rate of return, which
equates the present value of the expected benefits with the current market
value of the share, is the cost of equity.
The cost of equity capital is the most
difficult to measure. A few problems in this regard are as follows :
i)
The cost of equity is not the out of pocket cost of using equity capital.
ii)
The cost of equity is based upon the stream of future dividends as expected by
shareholders
(very difficult to estimate).
iii)
The relationship between market price with earnings is known. Dividends also
affect
the market value (which one is to be considered).
The following are the approaches to
computation of cost of equity capital :
E / P Ratio Method : Cost of equity capital is measured by earning price
ratio.
Symbolically
Eo (current
earnings per share)
----- * 100
Po (current market price per share)
The limitations of this method are :
Earnings
do not represent real expectations of shareholders.
Earnings
per share is not constant.
Which
earnings-current earnings or average earnings (It is not clear).
The method is useful in the following
circumstances :
The
firm does not have debt capital.
All
the earnings are paid to the shareholders.
There
is no growth in earnings.
E / P Ratio + Growth Rate Method :
This method considers growth in earnings. A
period of 3 years is usually being
taken into account for growth. The formula will be as
follows :
Eo (1 + b) 3
-------------
Po
Where
(1 + b) 3 =
Growth factor where b is the growth rate as a percentage and estimated for a
period of three years.
D /
P Ratio Method
: Cost of equity capital is measured by dividends price ratio.
Symbolically
Do (Dividend per share)
----- * 100
Po (Market price per share)
The
following are the assumptions :
i) The risk remains unchanged.
ii) The investors give importance
to dividend.
iii) The investors purchase the
shares at par value.
D /
P + Growth Rate Method : The method is comparatively more realistic as i) it
considers future growth in
dividends, ii) it considers the capital appreciation.
Thus
D1 D1
Po = -------- or
Ke = ------- + g
Ke -
g Po
where,
Po = the current price of the
equity share
D1 = the per share dividend
expected at the end of year 1.
Ke = the risk adjusted rate of
return expected an equity shares.
G = the constant annual rate growth
in dividends and earnings.
The equation indicate that the cost
of equity share can be found by dividing the
dividend expected at the end of the
year 1 by the current price of the share and adding the
expected growth rate.
Examples:
1. A firm has Rs. 5 EPS and 10% growth
rate of earnings over a period of 3 years. The current market price of
equity share is Rs. 50
Rs. 5 (1+.10)
3
Ke = ------------------ * 100
Rs. 50
Rs.
5 (1.331) 6.655
Ke = ------------------
* 100 = --------------- * 100
Rs. 50 50
=
13.31%
2. Raj Textiles Ltd. wishes to
determine its cost of equity capital, Ke. The prevailing market price of the
share is Rs. 50 per share. The firm expects to pay a dividend of Rs. 4 at the end of the
coming year 2003. The dividends paid on the equity shares over the past six years are
as follows :
Year Dividend (Rs.)
2002 3.80
2001 3.62
2000 3.47
1999 3.33
1998 3.12
1997 2.97
The firm maintained a fixed
dividend payout from 1996 onwards. The annual growth rate
of dividends, g , is approximately
5 percent. Substituting the data in the formula
Rs. 4
Rs. 50 = ------------
Ke - 0.05
Rs. 4
Ke = ------------ + 0.05
Rs. 50
= 0.08 + 0.05 = 13%
The 13% cost of the equity share
represents the return expected by existing
shareholders on their investment so
that they should not disinvest in the share of Raj
Textiles Ltd. and invest elsewhere.
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