MST531: Cost of Internal Equity Capital

Lecture 20
Cost of Equity Capital
The cost of equity capital is the
rate of dividend expected by the
investors, or
It is the shareholders’ required rate
of return, which equates the
present value of all expected future
dividends with the market value of
a share.
Cost of Equity Capital
Cost of Internal Equity:
•The firm’s internal equity consists of
retained earnings. Retention of earnings
deprives the shareholder from income
•This cost of retained earnings is the
income foregone by the shareholder.
•It can also be considered as an opportunity
cost to a shareholder who could have
invested the dividend income elsewhere
Opportunity Cost of Capital

The opportunity cost of retained

earnings is the rate of return, which
the ordinary shareholders would
have earned on these funds if they
had been distributed as dividends to
them.
Cost of Internal Equity
The Dividend-Growth Model:
1. Normal Growth: Dividends grow with
a constant rate every year

It is calculated from:
∞ (𝒕−𝟏)
𝑫𝑰𝑽𝟏 (𝟏 + 𝐠) 𝑫𝑰𝑽𝟏
𝑷𝒐 = ෍ =
(𝟏 + 𝒌𝒆)𝒕 𝒌𝒆 − 𝐠
𝒕=𝟏
 Cost of Internal Equity
The Dividend-Growth Model:
1. Normal Growth:
Cost of Equity = Expected Dividend Yield
+ Capital Gain
DIV1
ke  g
Where P0
DIV1 = Expected dividend after 1 year
P0 = Market price of equity share
g = Constant dividend growth rate
 Cost of Internal Equity
The Dividend-Growth Model:
2. Supernormal Growth :
n
DIV0 (1  g s )t DIVn  1 1
P0    
t=1 (1  ke ) t
ke  g n (1  ke ) n
Where
DIV0 = Current dividend
P0 = Market price of equity share
gs = Super-normal growth rate
gn = Normal perpetual growth rate
 Cost of Internal Equity
The Dividend-Growth Model:
3. Zero Growth:
Cost of Equity = Expected Dividend Yield
DIV1 EPS1
ke   (since g  0)
P0 P0
Where
DIV1 = Expected dividend after 1 year
DIV1 = DIV0(1+ g)
P0 = Market price of equity share
Cost of Internal Equity: Illustration
X ltd has its shares of Rs. 10 each
quoted on the stock exchange and the
current price per share is Rs. 36. The
dividends per share over the last four
years have been Rs. 1.40, Rs. 1.54, Rs.
1.69 and Rs. 1.86. Therefore the dividend
has been growing at roughly 10% p.a.
Calculate the cost of equity shares.
Cost of Internal Equity: Illustration
The dividends are growing at 10% and
expected to grow at this rate.
Expected current year dividend
𝐷0 = 𝑅𝑠. 1.86
𝐷1 = 𝐷0 1 + 𝑔 = 𝑅𝑠. 1.86 1 + 0.10 = 𝑅𝑠. 2.05

𝐷1 𝑅𝑠. 2.05
𝑘𝑒 = +𝑔 = + 0.10
𝑃0 𝑅𝑠. 36

= 0.057 + 0.10 = 0.157 or 15.7%

Thank you

Prof. Narinder Verma

School of Business Management and Liberal Arts
Shoolini University
Village Bajhol, Solan (H.P)

+91 9816080528
narinderverma@shooliniuniversity.com