Corporate Finance

Estimation of Cost of Capital 
 93

OTHER APPROACHES FOR ESTIMATION

OF COST OF EQUITY

There are two other popular methods for calculating cost of equity: DCF approach and Risk premium approach.

DCF Approach

The price of a stock, P 0 , on the day the most recent dividend, D 0 , is paid, is the present value of future

dividend stream.

P 0 = ∑

∞

=

++

1

0 ) 1( / (1 )

t

t rgD t

where

g = per period growth in dividends, and

r = investor’s expected rate of return.

The rate of return that equates the current market price and future dividend payments is the cost of equity

for the firm.

The model is based on some assumptions:

• The future rate of growth, g, is constant.


• The rate at which the investor discounts future cash flows, r, is constant.


• Dividends are paid annually.


• The cost of equity is calculated on the day the most recent dividend is paid.

If we assume that the dividends grow at constant rate forever,^2

P 0 = [D 1 / k – g]

K= [D 1 / P 0 ] + g

Cost of equity = Next period dividend yield + Growth in dividends

The normal practice is to use a two-stage dividend growth model as shown below.

The expected future dividend stream can be split into two periods—non-constant growth period (say 4

years) and constant growth period thereafter.

P 0 =^ [1/(1 ])

( – )

(1 )

) 1(

···

) 1(

4 4

4

4

1

(^1) k
gk
gD
k

D

k

D

+

+

+

+

++

+

(^2) This is the famous Gordon Model.