Conceptually, the cost of equity capital for a firm is the minimum rate of return necessary
to induce investors to buy or hold the firm’s stock. This required return is sum of the
basic yield covering the time value of money plus a premium for risk. In the operational
terms, it is the required rate of return of equity investors. There are two models,
commonly employed to measure the cost of equity investors. There are two models,
commonly employed to measure the cost of equity capital: (i) Model of Gordon-Shapiro
(more popularly known as dividend valuation model), and (ii) Capital asset pricing model
(CAPM).
- Dividend Valuation Model
This model is similar to Porterfield’s approach. It is based on a hypothesis that the
market price of a share at any point of time is the sum of the present values of future
dividend.
If it is expected that past growth of dividend is likely to continue in future years as well.
The rate of dividend can be determined on the basis of dividends paid in preceding years.
However, if the expected rate of growth is likely to be different, the expected future rate
of growth of dividends needs to be estimates.
- Capital Asset Pricing Model (CAPM) Approach
This model emphasizes the aspect of systematic (non-diversifiable) risk. According to
CAPM approach, the cost of equity capital is a function of riskless rate of return
(generally rate of return on treasury bonds), market rate of return consisting of expected
return on the market portfolio comprising all risky assets) and the beta (ß) parameter i.e.,
measure of non-diversifiable risk.
The CAPM approach clearly brings to the fore that cost of equity share capital is a
function of (i) risk free rate of return, (ii) market risk premium expected rate of return on
the market portfolio consisting of the risky assets minus Rate of return on risk free asset
and (iii) the systematic risk of the particular security. The principle underlying the
CAPM approach is in conformity with the basic finance theory related to risk and return,
i.e. the higher is the risk, the higher is the required rate of return of vice-versa.
- Access to foreign financial markets
It is not uncommon for many multinational corporate enterprises to have their securities
quoted on several stock exchanges in foreign countries. The quoting on several markets
permits multinational groups to attract a larger number of investors and this in turn results
into a greater demand for their shares, leading to the lower cost of equity capital.