“There are different approaches to the computation of cost of equity capital and there is no explicit cost of retained earnings” Critically comment.
Answers
Explanation:
. Dividend price approach
According to dividend price approach, we can calculate cost of capital just dividing dividend per share with market value of per share. This cost shows direct relationship between price of equity shares and price of dividend. Its % value shows what amount, we are giving per $ 100 share.
Ke = D/P
This model assumes that dividends shall be paid at a constant rate to perpetuity. It ignores taxation. Assume a $ 10/- share quoted at $ 25/-, dividend just paid of $ 2/-
Ke= 2/25 = 0.08 or 8%
Above is simple approach, but these days, we also include inflation adjustment in calculating cost of equity capital with dividend price approach.
Ke = D(1+ growth rate/100)(1+inflation rate/100) / Price of per share + (growth rate + inflation rate)
Suppose, if in above example, growth rate is 5% and inflation rate is 6% , then
Ke = Rs. 2 ( 1.05 X 1.06 )/$ 25 + ( 5% + 6% ) = 2 (1.113)/25 + 0.11 = 20.2%
2. The earning/price approach
This approach tells that we should not co-relate dividend per share with market value per share but we should use total earning and try to co-relate it with market value of shares. We have to just write earning per share of company instead writing dividend per share. It will be helpful to void the effect of dividend policy on calculation of working capital.
3. Realised yield approach
This approach is improvement in dividend price approach for calculating cost of capital. In this approach, we calculate cost of capital after analysis past payments of dividends. After this, we add some rate of growth % in basic formula of cost of equity capital. In realised yield approach, dividend on per share will be real value not expected value.
Remember the following points before applying the approaches of cost of capital:-
[*] Before applying any approach in company, we should see the expectation of investors. According to expectations and current earning level, we have to decide to add some % of growth and inflation in real dividend per share for calculating cost of equity capital.
[*] If there is high value of credit sale and other outstanding incomes, then we can use earning or price approach for knowing correct cost of capital.