Cost of Equity Capital

Firms may raise equity capital internally by retaining earnings. Alternatively, they could distribute the entire earnings to equity shareholders and raise equity capital externally by issuing new shares. In both cases, shareholders are providing funds to the firms to finance their capital expenditures. Therefore, the equity shareholders’ required rate of return will be the same whether they supply funds by purchasing new shares or by foregoing dividends which could have been distributed to them. There is, however, a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus, external equity will cost more to the firm than the internal equity.

Methods for Computation of Cost of Equity Capital

• Dividend Price Approach: Here, cost of equity capital is computed by dividing the current dividend by average market price per share.

• Earning/ Price Approach: The advocates of this approach co-relate the earnings of the company with the market price of its share.

Ke = (E/P)

• Realized Yield Approach: According to this approach, the average rate of return realized in the past few years is historically regarded as ‘expected return’ in the future. The yield of equity for the year is:

• Capital Asset Pricing Model Approach (CAPM): CAPM model describes the risk-return trade-off for securities. It describes the linear relationship between risk and return for securities.

Ke = Rf + b (Rm − Rf)