Cost of Equity Capital
The cost of equity capital is by far, conceptually speaking, the most difficult and controversial cost to measure, It has been shown in the preceding discussions that the coupon rate of interest which form s the basis of calculation of cost of debt can be estimated with a high degree of accuracy since intersect payments as well as the return of the principal are contractual obligations. The return on preference shares, although not a contractual obligation, can also be estimated fairly accurately as they are fixed in terms of the stipulations governing the issue of such shares. In contrast, the return to the equity-holders depends upon the discretion of the company management. Apart from the absence of any definite commitment to receive dividend, the equity shareholders rank at the bottom as claimants on the assets of the company at the time of its liquidation. It may, therefore, appear that equity capital does not carry any cost. But this is not true. Equity capital, like other sources of funds, does certainly involve a cost to the firm. It may be recalled that the objective of financial management is to maximize shareholders wealth and the maximization of market price of the operational substitute for wealth maximization. When equity-holders invest their funds also expect returns in the form of dividends. The market value of shares is it function of that the shareholders expect and get. If the company does not meet that requirements of its shareholders and pay dividends, it will have an adverse effect on the market price of shares. A policy not paying dividends by a firm would be in conflict, in other words, with its basic objective, net present maximization. The equity shares, thus, implicitly involve a return in terms the dividend expected by the investors, and, therefore, carry a cost. In fact, the cost of equity relatively the highest among all the sources of funds. The investors purchase the shares, as mentioned, in the expectation of a certain rate of return. The quantum of the rate of return, on the business risk and financial risk of a company. The equity shares involve highest degree of financial risk since they are entitled to receive dividend and return of principal all other obligations of the firm are met. As a compensation to the higher risk exposure, holders of such securities expect a higher return and, therefore, higher cost is associated with them.
Conceptually, the cost of equity capital, k may be defined as the minimum rate of return that must earn the equity-financed portion investment project in order to liner the market price of the shares. To illustrate, suppose the required rate of return on equity shares of a firm is 12 per cent and the cost of debt is 8 per cent. Further assume that the policy is to used equity and debt respectively in the proportion of 75 . 25. The required rate of return of the project as a whole would he 11 per cent.
Thu, the expected rate of return on equity shares is just equal to the required rate of return of investors. If the project earns less than Rs 110 yearly, it would give a return on the equity-financed portion less than that required by the investors so that the market price of shares would decline. This rate of return is the cost of equity capital in theory.
The measurement of the above required rate of return is the measurement of the cost of equity capital. There are two possible approaches that can he employed to calculate the cost of equity capital: (i) dividend approach, and (ii) capital asset pricing model approach