Top 2 Sources of Cost of Equity Capital

This article throws light upon the top two sources of cost of equity capital. The sources are: 1. New Issues 2. Cost of Retained Earnings.

Source # 1. New Issues:

The computation of cost of equity share capital is, no doubt, a difficult and controversial task since different authorities have conveyed different explanations and approaches to it. At the same time, it is also very difficult to know the expected return which the shareholders as a class expect from their investment as they differ among themselves in order to predict or quantify the said return.

However, some of the approaches by which the cost of equity capital may be computed are noted below:

(a) Dividend Prices (D/P) Approach:

This approach is based on dividend valuation model. Under this approach, the cost of equity capital is calculated against a required rate of return in terms of future dividends. Accordingly, cost of capital (K_o) is defined as the rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. In short, it will be that rate of expected dividends which will actually maintain the present market price of equity shares.

As such, the cost of equity is measured by:

This approach gives due importance to dividends but it ignores one basic aspect that retained earnings has also an impact on the market price of equity shares.

This approach, however, assumes that:

(i) Market price of shares is influenced only by variations in earnings of the firm;

(ii) Future earnings, which can be expressed as an average, will grow at a constant rate.

Illustration:

A company issues equity-shares of Rs. 10 each for public subscription at a premium of 20% The company pays @ 5% as underwriting commission on issues price. Expected rate of dividend by equity shareholders is 25%. You are required to compute the cost of equity capital. Will your assumption be different if it is calculated on the basis of present market value of equity share which is only Rs. 16?

Solution:

The cost of capital is computed as under:

However, in case of Existing equity shares, it is better to calculate cost of equity shares on the basis of market price which is computed as under:

 

 

(b) Dividend Price Plus Growth:

Under this approach, cost of equity capital is determined on the basis of the expected dividend rate plus the rate of growth in dividend, i.e., this method substitutes earnings per share by dividend and recognises the growth in it.

Symbolically,

Illustration:

Calculate the cost of equity capital from the following particulars presented by X Ltd. The current market price of an equity share of the company is Rs. 0.80. The current dividend per share is Rs. 6.40. Dividends are expected to grow @ 8%.

Solution:

Illustration:

Determine the cost of equity shares of company X from the following particulars:

(i) Current Market Price of a share is Rs. 140.

(ii)The underwriting cost per share on new shares is Rs. 5.

(iii) The following are the dividends paid on the outstanding shares over the past five years:

(iv)The company has a fixed dividend payout ratio.

(v) Expected dividend on the new shares at the end of 1st year is Rs. 14.10 per share.

Solution:

For calculating the cost of funds raised by equity share capital, we are to estimate the growth rate of dividends. During the five years the dividends have increased from Rs. 10.50 to Rs. 13.40 presenting as compound factor of 1.276 {i.e., Rs13.40/10.50}.

After applying the “compound sum of one rupee table” we know that a sum of Re. 1 would accumulate to Rs. 1.276 in five years @ 5% interest. Therefore, substituting the values in the above formula we get,

(c) Earning Price {E/P}, Approach:

Under this approach, earning per share will actually determine the market price per share. In other words, the cost of equity capital is equivalent to the rate which must be earned on incremental issues of ordinary shares so as to maintain the present value of investment intact, i.e., the cost of equity capital is measured by the earning price ratio.

Symbolically,

This approach recognises both dividends and retained earnings. But there are difference of opinion among the supporters of the approach about the applicability of both earnings and market price figures. Someone prefers to use the current earning rate and current market price.

While some others recognise average rate of earning (which is based on the earnings of past few years) and the average market price of equity shares (which is based on market price for the last few years).

Illustration:

The capital structure of a company is: 1, 00,000 equity shares of each Rs. 100 each.

Its current earnings are Rs. 10,00,000 per annum The company desires to raise an additional funds of Rs. 20,00,000 of the issues of new equity shares The flotation costs are expected <8 10% on face value What will b# the cost of equity capital if it is assumed that earnings of the company are stable?

Solution:

(d) Realised Yield Approach:

Under this approach, cost of equity capital is determined on the basis of actual realised return by the investors on their investment, i.e., on equity shares. In other words, cost of equity capital is computed on the basis of dividends (which are taken from the past records) and the actual capital appreciation in the value of equity shares which are held by them.

This approach is particularly applicable in those companies where the dividends are stable and the growth rate is almost constant. In short, this approach assumes that past behaviour will be repeated in future at a reasonable degree of certainty.

Illustration:

Mr X, a shareholder of P & Co., purchased 5 shares at a cost of Rs. 260 on 1.1.1983. He retained the shares for 5 years and sold them on 1.1.1988 for Rs. 325.

The dividend which he received for the last five years are as under:

Calculate the cost of equity capital.

Solution:

Before calculating the cost of equity capital, we are to compute the Internal Rate of Return (IRR) which can be calculated with the help of “Trial and Error Method’ (discussed subsequently in the present volume).

The rate comes to 10% which is shown as under:

Thus, the present value of cash flows as 1st Jan. 1988 amounts to Rs. 260.73 as against the purchase price of 5 shares on 1st Jan. 1983 which was Rs. 260. Therefore, at 10%, the PV of cash inflow will be equal to an outflow over a period of 5 years in the year 1983. As such, the cost of equity capital will be considered at 10%.

Source # 2. Cost of Retained Earnings:

Generally, the companies do not distribute the entire profits by way of dividend among their shareholders. A part of such profits is retained for future expansion and development. It may lead to growth in both cash flow earnings and in dividends.

Retained earnings, like equity funds, have no accounting cost but do have an oppor­tunity cost. The opportunity cost of retained earnings is the dividend foregone by the shareholders.

In other words, if the company retains cash flows, the equity sharehold­er foregoes the return he could have obtained if these funds were paid out. He receives higher dividends in future. Those projects whose expected extra future dividends at least cover these foregone opportunities should be financed by retained earnings.

As such, the cost of equity reflects the return which shareholders would receive if cash flows were paid out by way of dividends. Thus, the cost of retained earnings is the earnings foregone by the shareholders, i.e., it is equal to the income what a share­holder could have earned otherwise by investing the same in an alternative invest­ment.

For instance, if a shareholder could have invested the said funds in an alternative way they could have a return of, say, 12%. This return is actually foregone by them simply due to the fact that the company does not distribute the entire profits by way of dividend. In this case, the cost of retained earnings may be taken at 12%.

It can alternatively be explained as under:

Suppose the profits/ earnings are not retained by the company and distributed by way of dividend to the shareholders which are invested by the shareholders in purchasing shares of the same company. Now, their expectation about the return on such new equity shares may be considered as the opportunity cost of retained earnings.

In short, if earnings/profits were distributed by way of dividend and at the same time if an offer is made for right issue, the shareholders would have subscribed the right issues with the expectation of a certain return which is taken also as the cost of retained earnings.

The example that we have presented above reveals that the shareholders could have invested the dividends in the firms of similar risk and earned a return at least equal to the cost of equity if the dividends would have been paid to them, i.e., it ignores the effect of personal taxation, brokerage and floatation costs of the new issues.

Because, in actual practice, they must have to pay tax, brokerage, commission etc. Therefore, the funds which are available to the shareholders should be less than what they would have been if the same had been retained by the company. Thus, the cost of retained earnings should always be less than the cost of new equity shares issued by the company.

However, the following adjustments are to be made in order to determine the cost of retained earnings:

(i) Adjustment for Income-Tax:

Needless to mention that the dividends which are received by the shareholders are subject to income-tax. The dividend that the shareholders receive is the net dividend (i.e., gross dividend minus income-tax) and not the gross dividend.

(ii) Adjustment for Brokerage, Commission etc:

Generally, when a shareholder wants to purchase new shares against the dividend that he receives, he is to incur some expenses by way of brokerage, commissions, etc., i.e., they cannot utilise the entire amount of dividends so received for the purpose of investment since he is to pay such expenses.

It should be remembered in this respect that the opportunity cost of retained earnings is the rate of return what a shareholders can obtain by investing net dividends against alternative investment.

The cost of retained earnings after making proper adjustments for income-tax and brokerage cost can be measured with the help of the following formula:

Illustration:

Annual Net Profit is earned by a company amounted to Rs. 50,000. Shareholders’ required rate of return is 10%. It is expected that retained earnings can be invested by the shareholders against a similar type of company is 10%, if the same are distributed among the shareholders. Shareholders also have to incur by way of brokerage and commission @ 3% of the net dividends Rate of tax is @ 40%.

Calculate the cost of retained earnings.

Solution:

Before calculating the cost of retained earnings it becomes necessary to calculate the net amounts which are available for investment by the shareholders and their expected rate of return which is calculated as under:

Now, if the net earnings had not been distributed by the company among the shareholders, the company could re-invest full Rs. 50,000 instead of Rs. 29,100.

The rate of return to be earned on the retained earnings to the shareholders will be as under:

Therefore, the rate of return expected by the shareholders on retained earnings is only 5.82%.

The same can also be calculated with the help of the above formula:

The fundamental difficulty in the above approach is to determine the marginal tax rate of all the shareholders which will correctly reflect the opportunity cost of retained earnings to every shareholders. There are some authorities who prefer to use another approach known as “External Yield Criterion”.

Under this approach, the opportunity cost of retained earnings is the rate of return which can be earned by investing the funds in outside securities, i.e., cost of retained earnings is the return on direct investment of funds and not the amount that the shareholders are able to receive on their investment.

That is, this approach reveals the justifiable opportunity cost which can consistently be applied. Besides, computation of marginal tax rate does not arise under this approach. However, this method may not be universally accepted. As such, many accountants prefer to compute the cost of retained earnings at par with equity share capital.