One approach to calculate the cost of equity capital is based on the dividend valuation model. According to this approach, the cost of equity capital is calculated on the basis of a required rate of return in terms of the future dividends to be paid on the shares. The cost of equity capital, k, is, accordingly, defined as the discount rate that equates the present value of all expected future dividends per share the net proceeds of the sale (or the current market price) of a share.
The process of determining ke is similar to that used in calculating the explicit before-tax cost of debt (kd) and cost of preference capital. The two elements of the calculation of k on the basis of the dividend approach are (i) net proceeds from the sale of a share/current market price of a share, and (ii) dividends and capital gains expected on the share. In arriving at the first, that is the sale proceeds current price, adjustments for flotation cost and discount/premium are necessary. In the case of dividends, the investors expect a rate of dividend which will not be constant over the years but will grow. The growth in expected dividends in future may be either at a uniform normal rate perpetually or it may vary so that for a few years it may be at level higher than in subsequent years after which it will increase at a normal rate. While calculating the cost of equity capital therefore, the dividend approach takes into account expected dividend under different growth assumptions.
The cost of equity capital can be measured with the following equations:
(A) When dividends are expected to grow at a uniform rate perpetually.
where D1 = Expected dividend per share
Po = Net proceeds per share/current market price
g = Growth in expected dividends
The calculation of k, on the basis of Eq. 12.12 is based on certain assumptions with respect to the behavior of investors and their ability to forecast future values:
• the market value of shares depends upon the expected dividends:
• investors can formulate subjective probability distribution of dividends per share expected to be paid in various future periods;
• the initial dividend, Do is greater than zero (D, > 0);
• the dividend pay-out ratio is constant;
• investors can accurately measure the riskiness of the firm so as to agree on the rate at which to discount the dividends.