10/30/2022 0 Comments Current cost basis of measurement![]() ![]() X, a shareholder of P & Co., purchased 5 shares at a cost of Rs. In short, this approach assumes that past behaviour wall be repeated in future at a reasonable degree of certainty. This approach is particularly applicable in those companies where the dividends are stable and the growth rate is almost constant. 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. Under this approach, cost of equity capital is determined on the basis of actual realised return by the investors on their investment, i.e. ![]() What will be the cost of equity capital if it is assumed that earnings of the company are stable?īy earning price ratio, the cost of equity capital is: The flotation costs are expected 10% on face value. 20,00,000 on the issue of new equity shares. The company desires to raise an additional fund of Rs. Some prefer 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). But there is difference of opinion among the supporters of the approach about the applicability of both earnings and market price figures. This approach recognises both dividends and retained earnings. the cost of equity capital is measured by the earning price ratio. 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. Under this approach, earning per share will actually determine the market price per share. = 15.44% (c) Earning Price (E/P) Approach: Therefore, substituting the values in the above formula we get After applying the “compound sum of one rupee table” we know that a sum of Re. 13.40 presenting as compound factor of 1.276, i.e. During the five years the dividends have increased from Rs. 14.10 per share.įor calculating the cost of funds raised by equity share capital, we are to estimate the growth rate of dividends. (v) Expected dividend on the new shares at the end of 1st year is Rs. (iv) The company has a fixed dividend pay-out ratio. (iii) The following are the dividends paid on the outstanding shares over the past five years: 2,400 (16,000 x 15), it will provide a less return to the inventors and as a result, market value of share will go down.Ĭonceptually, this rate of return may be considered as the cost of equity capital which is determined by the following two categories: But if the project earns a return which is less than Rs. In other words, the market value of shares will go up. Therefore, the expected rate of return is 21.88% which is above the IRR and, as such, the project may be undertaken. 4,000, the rate of return on equity financed portion can be computed as: 20,000 for a project which gives an annual return of Rs. ![]() It indicates that if the company requires Rs. For instance, if the required rate of return (RRR) is 15% and cost of debt is 12½%, and if the company has the policy to finance with 80% equity and 20% debt, the RRR of the project would be computed as: The equity shareholders take the highest degree of financial risk, i.e., they receive dividend after paying off all the business obligations and, since they take the highest degree of risk, naturally, they expect a higher return and, as such, highest costs are related to them.Ĭost of equity capital may be defined as the minimum rate of return that a firm must earn on the equity-financed portion of an investment project in order to leave unchanged the market prices of its stock. It has been stated above that the equity shareholders always expect a certain rate of return which, again, depends on, inter alia, the business risk and financial risk of a firm. (a) New Issues, (b) Retained Earnings.Ĭonceptually speaking, the cost of equity capital is comparatively the highest among all other sources of funds. Equity financing arises from two major sources, viz. It may be mentioned that equity funds should be used only when the return from a project covers this cost. ![]()
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