The document discusses various methods for calculating the cost of equity capital, including the dividend price ratio, earning price ratio, and growth rate approaches. It provides detailed examples and formulas to illustrate how to compute costs using different parameters such as dividends, earnings per share, and market prices. Additionally, it addresses the cost of retained earnings, considering factors like tax rates and brokerage costs.

1. FINANCIAL MANAGEMENT
COST OF CAPITAL
BY:
SMT.UMA MINAJIGI REUR
HEAD, DEPT. OF COMMERCE& MANAGEMENT
SMT. V G DEGREE COLLEGEFOR WOMEN, KALABURAGI

2. COST OF EQUITY CAPITAL

3. COST OF EQUITY SHARE CAPITAL
Equity shareholders are not paid dividend at a fixed rate every year. The distribution of dividend depends
upon the profitability of the company.
The cost of Equity share is the minimum rate of return company has to earn.
The cost of equity capital several models have been proposed. The cost of equity capital is calculated
based on the following approaches:
1. Dividend price ratio approach
2. Earning price ratio approach
3. Dividend Price + Growth Rate of Earnings (p+g) Approach
4. Realised yield approach

4. DIVIDEND PRICE RATIO APPROACH
This method is suitable only when the company has stable earnings and
stable dividend policy over a period of time.
The cost of equity capital is calculated as follows:
𝐾𝑒 =
𝐷
𝑃
Where,
Ke = Cost of Equity
D = Dividend i.e, expected dividend rate per share.
P = Net proceeds i.e, current market price of equity shares.

5. 27. A company issues 2000 equity shares of Rs.100 each at a premium of 10%. The company has been paying 20%
dividend to Equity shareholders for the past 5 years and expects to maintain the same in the future also. Compute
the cost of equity capital. Will it make any difference if the market price of equity share is Rs.150 ?
Solution:
𝐾𝑒 =
𝐷
𝑃
Where,
Ke = Cost of Equity
D = Dividend rate = 20%
P = Net proceeds
= Face Value + Premium
= 100 + 10 = 110
𝐾𝑒 =
𝐷
𝑃
𝐾𝑒 =
20
110
∗ 100 = 18.18%
If the market price of a equity share is Rs.150.
𝐾𝑒 =
𝐷
𝑃
Where,
Ke = Cost of Equity
D = Dividend rate = 20%
P = Net proceeds
= Face Value
= 150
𝐾𝑒 =
𝐷
𝑃
𝐾𝑒 =
20
150
∗ 100 = 13.33%

6. Problems on Finding price of shares.
28. A is a shareholder in B ltd. Although earnings for the B Ltd has varied considerably. A has
determined that the long run average dividends have been Rs.4 per share.
He expects a similar pattern to prevail in the future. A has decided that a minimum rate of 20%
should be earned on the shares. What price would A willing to pay for the share of B Ltd.
Solution:
𝐾𝑒 =
𝐷
𝑃
Where,
Ke = Cost of Equity = 20
D = Dividend per share = Rs.4
P = Net proceeds ?
𝐾𝑒 =
𝐷
𝑃
20 =
4
𝑃
𝑃 =
4
20
= 0.2 ∗ 100 = 20%

7. EARNING PRICE RATIO APPROACH
According to this approach it is the earning per share which determines
the market price of the shares.
Thus, the cost of capital should be related to that earning percentage
which could keep the market price of the equity shares constant.
This approach is suitable when the earnings will be equal to the present
earnings. It means that growth rate is zero.

8. The cost of equity is calculated by the following formula:
𝐾𝑒 =
𝐸
𝑃
Where,
Ke = Cost of Equity
D = Earning per share.
P = Net proceeds i.e, current market price of equity shares.
Where the cost of existing capital is to be calculated:
𝐾𝑒 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ( 𝐸𝑃𝑆 )
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ( 𝑀𝑃 )

9. 29. The earning per share is Rs.10 and the current market price is Rs.100.
Compute the cost of equity capital.
Solution:
𝑲𝒆 =
𝑬
𝑷
Where,
Ke = Cost of Equity
E = Earning per share = Rs.10
P = Net proceeds = Rs.100 (Market Price)
𝐾𝑒 =
10
100
∗ 100 = 10%
Ke = Cost of Equity = 10%

10. 30. A company is considering expenditure of Rs.70,00,000 for expending its operations. The following information
provides. Number of existing equity shares 10,00,000 , Market value of existing share Rs.60 , Net Earnings
Rs.80,00,000.
Compute the cost of existing equity share capital and of new equity share capital assuming that new share will be issued
at a price of Rs.52 per share and the costs of new issue will be Rs.2 per share.
Solution:
Calculation of cost of existing capital :
𝐾𝑒 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ( 𝐸𝑃𝑆 )
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 ( 𝑀𝑃 )
Calculation of EPS:
𝐸𝑃𝑆 =
𝑁𝑒𝑡 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 𝑠ℎ𝑎𝑟𝑒𝑠
𝐸𝑃𝑆 =
80,00,000
10,00,000
EPS = Rs.8 per share

11. 𝐾𝑒 =
𝐸
𝑃
𝐾𝑒 =
8
60
∗ 100 = 13.33%
Cost of new Equity Capital:
𝐾𝑒 =
𝐸
𝑃
Where,
Ke = Cost of Equity
E = Earning per share = Rs.8
P = Net proceeds
= New Price – Cost of new share = 52 – 2 = 50
𝐾𝑒 =
8
50
∗ 100 = 16%
Cost of Equity Capital = 16%

12. DIVIDEND / PRICE PLUS GROWTH RATE OF EARNING APPROACH (D/P + Q)
This approach emphasizes what the investors actually receive as
dividend plus the rate growth (g) in dividend. The growth rate in
dividend is assumed to be equal to the growth rate in earnings per
share.
The earnings per share increases at the rate of 20% per share, the
dividend per share and the market price per share will also increase at
the rate of 20%.
This method is based on dividends and growth rate.

13. Formula for calculating cost of equity capital under this approach
is as follows:
𝑲𝒅 =
𝑫
𝑷
+ 𝑮
Where,
Ke = Cost of Equity Capital
D = Expected Dividend per share
P = Net proceeds per share
G = Rate of Growth in dividends (i.e, Growth rate in EPS)

14. Note: In case of cost of existing equity share capital is to be
calculated, the P should be replaced with MP (Market price per share)
in the above equation.
𝑲𝒅 =
𝑫
𝑴𝑷
+ 𝑮
Where,
Ke = Cost of Equity Capital
D = Dividend rate
MP = Current market price of shares
G = Rate of Growth in dividends (i.e, Growth rate in EPS)

15. 34. The current market price of an equity share of a company is Rs.80 but its face value is Rs.10. The
current dividend per share is Rs.5. In case of dividends are expected to grow at the rate of 9%. Calculate
the cost of equity capital.
Solution:
𝑲𝒅 =
𝑫
𝑴𝑷
+ 𝑮
Where,
Ke = Cost of Equity Capital
D = Dividend rate = Rs.5 per share
MP = Current market price of shares = Rs.80 per share
G = Rate of Growth in dividends = 9% = 0.09
𝑲𝒅 =
𝟓
𝟖𝟎
+ 𝟎. 𝟎𝟗
= 0.0625 + 0.09
= 0.1525 * 100
= 15.25%
Cost of equity capital = 15.25%

16. 35.
a. A company plans to issue 2000 new equity shares of Rs.100 eacg at par. The
floatation costs are expected to be 5% of the share price. The company pays a
dividend of Rs.10 per share initially and the growth in dividends is expected to be
5%. Compute the cost of new issue of equity shares.
b. If the current market price of an equity share is Rs.160. Calculate the cost of
existing Equity share capital.
36. The market price of share is Rs.250 and company plans to pay a dividend of
Rs.10 per share. The growth of dividends is expected to be at the rate of 12%.
Find out the cost of equity capital.

17. COST OF RETAINED EARNINGS
Undistributed profits are called Retained earnings.
Retained earnings are the sacrifices of the equity shareholders, so they expect a return
on retained earnings. Thus, the cost of retained earnings is the earnings foregone by
the equity shareholders.. This means that the opportunity cost of retained earnings
may be taken as the cost of retained earnings.
The cost of retained earnings is calculated as:
Kr = Ke (1-T) (1-B)
Where,
Kr = Cost of retained earnings
Ke = Cost of equity capital
T = Tax Rate
B = Brokerage Cost

18. 39. A company’s Ke (Return available to shareholders) is 20% the average tax rate of
shareholders is 40% and it is expected that 2% is brokerage cost that the shareholders
will have to pay while investing their dividends in alternative securities. What is the
cost of retained earnings ?
Solution:
The cost of retained earnings is calculated as:
Kr = Ke (1-T) (1-B)
Where,
Kr = Cost of retained earnings
Ke = Cost of equity capital = 20%
T = Tax Rate = 40% = 0.40
B = Brokerage Cost = 2% = 0.02
Kr = Ke (1-T) (1-B)
= 20% (1-0.40)(1-0.02)
= 20% (0.60 * 0.98)
= 0.20 (0.588)
= 0.1176 *100
= 11.76%
Cost of retained earnings = 11.76%

19. THANK YOU