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COST OF EQUITY ????

(Guest)

hi! can anyone tell me what is interpreted by cost of equity, preference capital and debt... the book says ke or cost of equity is the reqd rate of return... reqd by whom, the shareholders or the co? and is it equivalent to IRR?

please help...

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16 Replies

koolleo87 (1268 Points)
Replied 24 October 2007

IRR is the Internal Rate of Return ( a different concept ) while Ke or the Cost of Equity is the Return required by the shareholders of the company by means of Capital Appreciation ( Increase in market Value ) or Dividend, etc.... It is calculated to know the return to be generated to meet market expectations since that will keep the share price from falling...

CA.Saibaburao Nanduri (Chartered Accountant) (3847 Points)
Replied 24 October 2007

Definition of Cost of Equity:

In finance, the cost of equity is the minimum rate of return a firm must offer shareholders to compensate for waiting for their returns, and for bearing some risk.

The cost of equity capital for a particular company is the rate of return on investment that is required by the company's ordinary shareholders. The return consists both of dividend and capital gains, e.g. increases in the share price. The returns are expected future returns, not historical returns, and so the returns on equity can be expressed as the anticipated dividends on the shares every year in perpetuity. The cost of equity is then the cost of capital which will equate the current market price of the share with the discounted value of all future dividends in perpetuity.

The cost of equity reflects the opportunity cost of investment for individual shareholders. It will vary from company to company because of the differences in the business risk and financial or gearing risk of different companies.

The cost of equity is calculated by the following formula:

Cost of Equity = Next year's dividend per share/current market value of sock * Growth rate of dividends

Prakash Popat (3134 Points)
Replied 24 October 2007

Cost of Equity is normally Higher as expectation of Investors is normally higher,depend upon th eOther players in particulars Industry it's definately Higher than cost of borrowed funds.But only thing its that it's not compulsion on management,to give any assurance thereto but failure on the parts of management to fulfil expectations of shareholders will reflects in market performance of the scripts and therfore Cost of Equity is normally Higher than other funding options.

(Guest)

thank u all so much for the wonderful answers! i really appreciate it.

KAAPIL (COACHING ) (11717 Points)
Replied 06 November 2007

Cost of equity is the expectation of the investors.

ashok (CA) (112 Points)
Replied 16 November 2007

What happens when the Equity of the company is in negative? I mean equity is fully eroded and appears on the asset side of the balance sheet. Does cost of equity change in this case? How does such a situation affect computation of Weighted Average of Capital?

ashok (CA) (112 Points)
Replied 16 November 2007

What happens when the Equity of the company is in negative? I mean equity is fully eroded and appears on the asset side of the balance sheet.
Does cost of equity change in this case?
How does such a situation affect computation of Weighted Average Cost of Capital?

koolleo87 (1268 Points)
Replied 17 November 2007

The cost of equity is not relly affected by capitl appearing on the asset side of the balance sheet. It may happen that the company is a highly leveraged company and it is during the gestation period. So, losses are accumulated and transferred to capital account. But the shareholders contribution may not be able to cover up the losses. ( Remember, this is highly leveraged, so the debt equity ratio may be more than even 5:1). As said before, cost of equity is the expectation of the investors. IF they have faith in the company, the Market price may not fall. Take the case of Reliance Petroleum -- Although it has not yet commenced operations, the investor faith and expectations have sent stock prces to dizzying levels. So, the Co ll ve to work hard in order to deliver else the share price ll fall in the future.

ashok (CA) (112 Points)
Replied 17 November 2007

Agreed, ke is not affecting by equity appearing on b/s. But how do you take care of this in case of WACC?

koolleo87 (1268 Points)
Replied 17 November 2007

Ok in case of WACC then, v ll have to use the market value of the shares in order to judge and understand investor and market epectations. N accordingly, based on the MV of shares we can conclude the Cost of Equity. Although it becomes difficult at times, it has to be calculated. It is then solely on the skill of the finance Manager.

(Guest)

hey thanks!!

Praveen Kumar Daga (Student (CA Final)) (35 Points)
Replied 27 November 2007

Hi this is Praveen here, Firstly, internal rate of returen is that rate by discounting the inflow by which the Present value of inflow must must be equal with the initial outflow. Again in case of cost of capital, from co's point of view the inflow and outflow are as follows: Inflow : Issue price of shares Outflow : Redemption value and Dividend. Again we can say that the Cost of Equity is the rate by discounting the inflow and outflow by which PV of outflow is same as PV of Inflow

(Guest)

cost of equity means the consideration that the equity shareholders expect in lieu of contribution made by them to the capital of company.

Nelson (Fin Executive) (28 Points)
Replied 02 December 2009

Hello everyone, I m a newbie who had a query. I was calculating cost of equity 4 few companies last year. I was using the CAPM formula. Now since markets were falling continously around this time (Sept) last year, the returns of the market were less than the risk free rate and there was no equity risk premium giving the overall cost of equity a negative value. Now i undertsand that a positive cost of equity is incorporated in the WACC to work out the discounting rate. A negative cost of equity implies the opposite and would mean that the stock is going to fall further. However how do I ascertain the WACC in such a case. I had this query for over a year now. PLzz help