Different methods are employed to compute the Cost of Equity Share Capital :
- Dividend price approach
- Earning/ Price Approach
- Growth Approach or Gordon’s Model
- Cost of Convertible Debenture
Dividend Price Approach:
✓ This is also known as Dividend Valuation Model. This model makes an assumption that the dividend per share is expected to remain constant forever.
✓ Here, cost of equity capital is computed by dividing the expected dividend by market price per share as follows
Cost of Equity (Ke) = D/Po
Ke= Cost of equity
D = Expected dividend
P0 = Market price of equity (ex- dividend)
Earning/ Price Approach
- The advocates of this approach co-relate the earnings of the company with the market price of its share.
- Accordingly, the cost of equity share capital would be based upon the expected rate of earnings of a company.
- The argument is that each investor expects a certain amount of earnings, whether distributed or not from the company in whose shares he invests
Cost of Equity (Ke) = E/P
E = Current earnings per share P = Market share price.
Growth Approach or Gordon’s Mode:
As per this approach the rate of dividend growth remains constant. Where earnings, dividends and equity share price all grow at the same rate, the cost of equity capital may be computed as follows:
Cost of Equity (Ke) = D1 + g/ Po
D1 = [D0 (1+ g)] i.e. next expected dividend P0 = Current
Market price per share
g = Constant Growth Rate of Dividend
Cost of Convertible Debenture:
- Holders of the convertible debentures has the option to either get the debentures redeemed into the cash or get specified numbers of companies shares in lieu of cash.
- While determining the redemption value of the debentures, it is assumed that all the debenture holders will choose the option which has the higher value and accordingly it is considered to calculate cost of debt.