Cost of equity shares posted by Rajani Sharma

What is cost of equity shares? What are the various ways to measure the cost of equity
shares?Cost of equity share is the part of cost of capital which allows the payment to only the equity shareholders.
In this every shareholders get the shares for getting the return on the shares on which they are investing so much.
From company's perspective the company must earn more than cost of equity capital in order to be unaffected by the
market value of the shares of its.

To measure the cost of equity shares we have to follow the following ways:-

1) Dividend yield method or Price ratio method

In this the minimum rate of cost of equity shares will be equal to the present value of future dividend per share with
current price of a share.

Cost of equity shares= Dividend per equity/ Market price< /STRONG>

For example if there is a company which issues shares of Rs. 200 each a premium of 10%. The company
pays 20% dividend to equity shareholders for the past five years and expects to maintain the same in the
future also. Compute the cost of equity capital. Will it be different if market price of equity share is Rs. 260?

The solution can be found out by our formula which says
Cost of equity shares= Dividend per equity/ Market price
= 20*100/210
= 9.52%

If the market price of equity share is Rs. 260.
=20* 100/260 = 7.69%

2) Dividend yield plus growth in dividend method

It is based on the theory that company is growing and its shares market value is also on growth. So, because
of this shareholders are in need of simple dividend, so that company can provide the profit to them
according to the growth.

To calculate this formula is as follows:-

Cost of equity share = Dividend per equity/Market Price + Rate of growth in dividends

3) Earning yield method

In this cost of equity capital is minimum and the earning of the company should be considered on market
price of share. The formula for this is as follows:-

Cost of equity share = Earning per share / Market Price per share< /STRONG >

4) Realised yield method

This method removes the drawback which in the dividend yield method or earning yield method as both are
based on future estimation of dividend or earning. In the economics there are many factors which can't be
controlled and are very uncertain and if the risk is involved then the future planning can't be used and the
decision related estimation return on investment can't be considered. It is based on actual earning which is
earned on the amount of investment. The equity share capital is calculated as:-

Cost of equity share = Actual earning per share * 100
Cost of preference share capital is that part of cost of capital in which we calculate the amount which
is payable to preference shareholders in the form of dividend with fixed rate. Even, dividend to
preference shareholder is on the desire of board of directors ofcompany and preference shareholder
can not pressurize for paying dividend but it doesnt mean that calculation of cost of pref. share capital
is not necessary because, if we dont pay the dividend to pref. shareholders, it will affect on capability
to receive funds from this source.

Cost of pref. share capitals formula is given below.

Cost of Pref. Share capital (Kp) = amount of preference dividend/ Preference share capital

Kp = D/P

If we have obtained this preference share capital after some adjustments like premium or discount or
pay some cost of floatation, at that time, it is our duty to deduct discount andcost of floatation or
add premium in par value of pref. share capital.

In adjustment case cost of pref. share capital will change and we can calculate it with following way:-

Kp = D/ NP

D = Annual pref. dividend,

NP = Net proceed = Par value of Pref. share capital discount cost of floatation

Or NP = Par value of pref. share capital + Premium

There will no adjustment of tax rates because, dividend on pref. share capital is payable on net profit
after tax adjustment, so need not to do adjustment of tax for comparing it with cost of debt or cost of
equity share capital .

Some, time we issue redeemable preference shares whose amount is payable after some time.

At the time of maturity, we need to calculate cost of pref. share capital with following formula

Cost of redeemable pref. share capital =




D = Annual dividend

MV = Maturity value of pref. shares

NP = Net proceeds of pref. shares

N= number of years

This formula is little different from cost of non redeemable pref. share capital because, we have to
add, the benefit which we have given to pref. share capital at the time of maturity.

Suppose, we have to pay Rs. 10, 00,000 but at the time of issue of pref. share, we had paid Rs. 2 per
issue of pref. share. So, net proceed is Rs. 9,80,000 but if this amount is payable after 10 years at
10% premium, this will also benefit to pref. share capital and total cost of pref. share capital will
increase. Rate of dividend is 10%.

Cost of pref. share capital

= D + (MV NP )/n / (MV +NP) X 100

= 100,000 + ( 10,50,000- 9,80,000 )/ ( 10,50,000 + 9,80,000) x 100

= 100,000 + 7,000/ 10, 15,000 X 100

= 10.54%

If we compare it with simple cost of pref. share capital with following way
Kp = D/P X 100 = 100000 / 10, 00,000 X 100 = 10% it is same as dividend rate but Kpr is more than
Kp. So, Kpr will give you correct result.
















Concept Of Cost Of Retained Earning
The portion of net profit distributed to shareholders is called dividend and the remaining portion of
the profit is called retained earning. In other word, the amount of undistributed profit which is
available for investment is called retained earning. Retained earning is considered as internal source
of long-term financing and it is a part of shareholders equity.
Generally, retained earning is considered as cost free source of financing. It is because neither
dividend nor interest is payable on retained profit. However, this statement is not true. Shareholders
of the company that retains more profit expect more income in future than the shareholders of the
company that pay more dividend and retains less profit. Therefore, there is an opportunity cost of
retained earning. In other words, retained earning is not a cost free source of financing. The cost of
retained earning must be at least equal to shareholders rate of return on re-investment of dividend
paid by the company.

Determination Of Cost Of Retained Earning
In the absence of any information relating to addition of cost of re-investment and extra burden of
personal tax, the cost of retained earning is considered to be equal to the cost of equity. However,
the cost of retained earnings differs from the cost of equity when there is flotation cost to be paid by
the shareholders on re-investment and personal tax rate of shareholders exists.
i)Cost of retained earnings when there is no flotation cost and personal tax rateapplicable for
shareholders:
Cost of retained earnings(kr) = Cost of equity(ke) = (D1/NP)+g
where,
D1= expected dividend per share
NP= current selling price or net proceed
ii)Cost of retained earnings when there is flotation cost and personal tax rate applicable for
shareholders:
Cost of retained earnings(kr) = Cost of equity(ke) x 1-fp) (1-tp)
where,
fp = flotation cost on re-investment(in fraction) by shareholders
tp = Shareholders' personal tax rate.

Illustration
A company's share are currently selling for $ 120. The expected dividend and the growth rate are
$5.20 and 6% respectively. Then calculate the cost of retained earning.

Solution,
Cost of retained earning(kr) = (D1/NP)+ g
= (5.20/120) +0.60 = 0.1033 or 10.33%







The cost of debt is usually based on the cost of the company's bonds. Bonds are a company's long-term
debt and are little more than the company's long-term loans. The cost of newly issued bonds is the
best rate to use if possible when calculating the cost of debt.
If a company has no publicly-traded bonds, then the business owner can look at the cost of the debt
of other firms in the same industry in order to get an idea of the cost of debt.
Calculate the Cost of Debt Capital
The cost of debt capital is not simply the cost of the company's bonds. Since the interest on debt is
tax-deductible, you must multiply the coupon rate on the company's bonds by (1 - tax rate) to adjust
for this as follows:
Cost of Debt Capital = Coupon Rate on Bonds (1 - tax rate)
Flotation costs or the costs of underwriting the debt are not considered in the calculation as those
costs are negligible when it comes to debt.
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