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.

Ordinary shares

  • 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

Ordinary shares

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%

Ordinary shares

  • 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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