Question

An ordinary share of a company which engages no external financing, is selling for 50. EPS is 7.5 of which 60 percent is paid in dividends. The company reinvests retained earnings at 10 percent

Answer 1

Concept:

The cost of capital is the return a business must obtain to cover the expense of a capital project, such buying new machinery or building a new structure. According to the company's preferred or existing capital structure, cost of capital includes the costs of both equity and debt.

Given:

Market price of share 50

EPS 7.5

Find:

Cost of capital

Solution:

Cost of capital = 60/7.5 =0.15 (Price earning ratio method)or

Cost of capital = 4.5/7.5 =0.6 (Dividend price method)

Here Cost of capital is calculated using earning-price ratio formula. and dividend price method

Since there is only equity shares in the question cost of capital and cost of equity are same.

Earning price ratio:

Cost of equity = EPS/$P_{o}$

EPS = Earnings per share

Po = Current market price of share

Dividend price method:

Cost of equity = D/Po

D = Dividend = 7.5*60% = 4.5

Po = Current market price ratio

Cost of capital is 0.15 or 0.6

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