4.15 The EPS (Earning per Share) and the MVS (Market value of Shares) shall
not be affected because of new issue of shares. The interests of the
existing share holders shall be protected and the assets or liabilities are to
be shared on pro-rata basis by the existing and the new share holders in
case of winding up. Therefore the new shares shall not result in earning
the EPS and the MVS. In such cases, the return on new investment shall
be taken as cost of new shares, so that, the EPS or MVS will not be below
the return on new investment. The new issue of shares will often called as
external equity. The cost of this external equity can be calculated on the
basis of dividend. In such cases, the cost of equity is the dividend yield
plus the growth rate of shares. Such cost of equity must also be included
with the floatation expenses incurred towards new shares.4.16 The earnings method will also be used to measure the cost of external equity. In
this method, the cost of equity will be computer on EPR (Earning Price Ratio)
basis.
4.17 A company may allow the existing share holders to purchase new shares at a
given price. This is known as ‘Rights issues of shares’. It will be in the same
ratio as determined in the board policy of a company. It will not be compulsory
on the part of the existing shareholders to purchase the Right Shares. The existing
shareholder will have option of selling his right share also. In case of rights
shares, the cost of capital would be equal to cost of a direct issue of shares to the
public at large.
- 18 A company may have the system of converting bonds or debentures or preference
shares, after a prescribed period. The conversion may be at a specified price or at
the prevailing market price. Such securities are called as convertible securities.
In case of these convertible securities, the cost of capital shall be taken at that
discount rate which equates the after-tax interest plus the expected conversion
price. - Weighted Average cost of Capital
5.1 Financial decision must result in either accepting or rejecting a capital
expenditure proposal. For this purpose an analysis of the specific cost of capital
is required.
5.2 The use of debt finance may increase risk on the part of the shareholders and in
turn this may be increase the cost of equity. On the other hand, higher the use of
equity, may lead to increasing the debt borrowing capacity. Because of this effect
of one on the other, we have to use the cost of the capital in a composite sense.
This composite mix of capital is also known as WACC. We know that capital is
raised from different sources. The cost of each source varies from each other.
Therefore, weights are attached to each source depending on its cost. Putting all