Corporate Finance

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Corporate Finance

With a forecast of D 1 , D 2 , D 3 , D 4 , and g, the cost of equity can be found by trial and error. Elsewhere in
the world, analyst forecasts of dividend and constant growth rate is used to estimate the cost of equity.
Such services are not popular in India.
The constant growth rate in dividends can be calculated by multiplying the expected retention ratio in
year 4 with Return on equity.

g = (Retention ratio in year 4) * (ROE)

The Gordon Model could also be used for estimating risk premium.

P = [D 1 / (k – g)]

Extending the concept to the market as a whole:

Market value =

Required return on stocks – Expected growth rate

Expected dividends next year

Given the current market value, expected dividends and growth rate in earnings and dividends in the
long run, one can solve for required return on equity. Subtracting the risk-free rate from the required return
on equity yields risk premium.
To illustrate, if index value = 3,500, dividend yield on the index = 8 percent, expected growth rate =
7 percent:

3500 = [(0.08 × 3500) / (r – 0.07)]

Required return on equity = 15 percent

If the risk-free rate is 12 percent, the premium is 3 percent.

Risk Premium Approach

Under the risk premium approach, a risk premium is added to the yield (YTM) on the company’s bonds
(to reflect the higher risk borne by shareholders) to estimate cost of equity.

That is, Cost of equity = Bond yield + Risk premium.

The equity risk premium can be calculated in two ways: historic yield spread method and ex-ante yield
spread based on DCF analysis.
The historic risk premium is the difference between the average of annual returns on a stock index in the
past (say 10 years) and the average of annual returns on a bond index over the same period.

Historic yield spread = Average return on stock index – Average return on bond index

The ICICI bond index could be used for estimating yield spread. But the problem is that I-Bex is fairly
young. So the data would be available for a short period of time.
The normal practice is to use geometric return on the indices. The historic premium is then added to
company’s bond yield to obtain an estimate of cost of equity. The shortcoming of this method is that the
estimate is affected by the period chosen and end points of the period.