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Cost Of Equity Capital

Cost of Equity Assignment / Homework Help
The cost of equity capital is the minimum rate of return that a company must earn on the equity financed portion of its investments in order to maintain the market price of the equity share at the current level. The cost of equity capital is rather difficult to estimate because there is no definite commitment on the part of the company to pay dividends. However, there are various approaches for computing the cost of equity capital. They are:

  • The SML approach or CAPM model

    This is a popular approach to estimate the cost of equity. According to the SML, the cost of equity capital is:

    Ke = Krf + ß (Km - Krf)

    Where:

    Ke      = Cost of equity
    Krf      = Risk-free rate
    Km     = Equity market required return (expected return on the market portfolio)
    ß        = beta

    Example:

    Let us calculate the cost of equity capital for a company whose Risk-free rate =10%, equity market required return =18% with a beta of 0.5.

    Ke      = 0.10 + 0.5(0.18 - 0.10)
              = 0.14 or 14%.

  • Bond Yield Plus Risk Premium Approach

    This approach is a subjective procedure to estimate the cost of equity. In this approach, a judgmental risk premium to the observed yield on the long-term bonds of the firm is added to get the cost of equity.

    Cost of equity     =     Yield on long-term bonds + Risk Premium.

    Example:

    Given, the yield on debt is 10% and the risk premium as 5%, calculate the cost of equity.

    Cost of equity = 0.10 + 0.05 = 0.15 or 15%.

    Firms that have risky and consequently high cost of debt will also have risky and consequently high cost equity. Thus it makes sense to base the cost of equity on a readily observable cost of debt. The disadvantage or a challenge to this approach is the determination of the risk premium. There is no objective way to determine it and hence many financial analysts look at the operating and financial risks of the business and arrive at a subjectively determined risk premium that ranges between 2 percent and 6 percent.



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  • Dividend Growth Model Approach

    The price of an equity stock depends ultimately on the dividends expected from it. It can be represented as follows:
    Cost of equity Assignment / Homework Help
    So, the equation becomes Cost of equity Assignment / Homework Help

    Where:

    P0       = Current price of the stock
    D1      = Expected dividend at the end of year 1
    D2      = Expected dividend at the end of year 2 and so on..
    t         = Year t
    r         = Equity shareholders' required rate of return

    If the dividends are expected to grow at a constant rate of g% per year, then the equation becomes:

    Cost of equity Assignment / Homework Help

    Simplifying this equation, we get:
    Cost of equity Assignment / Homework Help and solving for r, we get Cost of equity Assignment / Homework Help

    Example:

    A company has issued 5000 equity shares of $100 each. Its current market price is $95 and the current dividend is $4.5 per share. The dividends are expected to grow at the rate of 6%. Compute the cost of equity capital.

    Here, D1 = $4.5 + growth rate 6% = $4.77 per share

    P0 = $95

    Ke = $4.77 + 6% = 0.11 or 11%
             $95


  • Earnings-Price Ratio approach

    According to this approach, the cost of equity capital is:

    Ke = E1
             P0

    Where:

    E1     = Expected earnings per share for the next year
    P0     = Current market price per share

    E1 can be calculated as (Current EPS) * (1 + growth rate of EPS)

    Example:

    A company has currently 10,000 equity shares of $100 each and its’ earnings are $150,000. Its’ current market price is $112 and the growth rate of EPS is expected to be 5%. Calculate the cost of equity.

    Current EPS  =  Earnings available for equity shareholders
                                         Number of equity shares

                           ->  $150,000 / 10,000 shares = $15 per share.

    E1 = $15 + 5% = $15.75 per share
    Ke = $15.75 / $112 = 0.14 or 14%.

    This approach provides an accurate measure of the rate of return required by equity shareholders in the following 2 scenarios:

    • When the EPS are expected to remain constant and the dividend pay-out ratio is 100%.
    • When retained earnings are expected to earn a rate of return to the rate of return required by the equity shareholders.

    Because both are quite unrealistic and rare, the other approaches are preferred over this approach to calculate the cost of equity capital.