What is the cost of capital?
- All providers of finance require returns.
- The required return will reflect the risk of the investment and the returns of alternatives.
- Companies need information about the cost of different sources of finance in order to find the overall cost of finance and make investment and financing decisions.
- Perhaps an ‘optimum’ capital structure exists, which a firm can seek to achieve.
- The cost of equity can be found from the rearranged dividend growth model:
Ke = cost of equity
P0 = the current ex-div share price
D1 = the dividend received each year
g = the expected growth rate of dividends
Calculating Ke using dividend growth model:
- Current ex div share price: 176p
- Current dividend per share: 20p
- Expected dividend growth rate: 5%
- Next year’s dividend (D1) = 20 × 1.05 = 21p
- Ke = (21/176) + 0.05 = 0.119 + 0.05 = 0.169
- Ke = 16.9%
- The cost of equity can also be found from the CAPM:
Rj = Rf + βj (Rm – Rf)
Rm = return of the market
Rf = risk-free rate of return
(Rm – Rf) = equity risk premium
βj = beta value of ordinary share
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