There are two means of getting finance from common stocks namely:
- Retained earnings or internal common equity(Ke)
- External common equity (Kne)- the issuance of NEW common stocks.
Let’s see how we can compute the aforesaid’s cost of capital
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Methods To Compute Of Cost Of INTERNAL Common Equity
- Dividend Growth Model
- Capital Asset Pricing Model (CAPM)
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Dividend Growth Model
- The value of common stock is equal to the PRESENT VALUE OF EXPECTED FUTURE DIVIDENDS, discounted at the stockholders’ required rate of return
- Formula is Po = D1/(Ke-g)
Where Po = price of the stock today
D1= dividend at the end of the first year
Ke= required rate of return on equity
g = constant growth rate of dividends
If dividends are paid at a constant annual rate of growth(g) which is less than Ke:
Ke= Dividend in year 1/Market price + Annual growth rate in dividends
Therefore Ke(Required rate of return)= D1/Po + g
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Illustration Using the DIVIDEND GROWTH MODEL BASIS
Company XYZ Ltd’s recently received $0.15 dividend per share and expect dividends to growth at an annual rate of 10%. The market price of the security is $3, compute the investors’ required rate of return using the Dividend Growth Model:
Suggested Solution:
Ke( Required rate of return)
= D1/Po + g
= $0.15(1+0.1) / $3 + 0.1
= $0.165/3+0.1
=0.155
=15.5%
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Some of the major factors which affect a firm’s cost of capital are:
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1.0 Dependent on the overall country’s economic conditions
- When inflation rate is increasing, cost of doing business is more expensive hence investors and lenders will demand a higher rate of return which results in a higher cost of capital
- When the economy is on its upbeat trend where demand for funds increases and supply of funds are limited or not increasing proportionately to demand then the lenders and financiers increase their lending rate which will also increase a firm’s cost of capital
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2.0 Dependent on the company’s business risk
- The higher a firm’s business risk, the higher the investors’ required rate of return and the cost of capital will also increased.
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3.0 Dependent on the company’s financial risk
- Where a company is highly geared, the lending institutions will consider the firm’s financial risk to be quite high hence would require a higher rate of return from the firm hence increasing the firm’s cost of capital
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4.0 Dependent on the Size of Financing
- Where the firm’s size namely its assets or sales turnover cannot justify the size of financing needs, the lenders will be more cautious and will impose a higher cost of fund which will then increase the company’s cost of capital
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