Cost of Equity Capital
The cost of equity is by far the most difficult cost to measure and raises a whole lot of problem. Its purpose is to enable the corporate management to mark decisions in the best interest of the equity holders. An investment decision that results in maximizing the present value of equity owner’s holding in a company would be satisfactory to them.
In concept, the cost of equity may be defined as the minimum rate of return that the firm must earn on equity financed protion of an investment project so that the market price of the equity share remains unchanged (Horngren, and Van Horne). Thus, the cost of equity capital is equal to the return required by equity shareholders. There are three variations to this approach to cost of equity ; (a) B/P (Earning/Price ratio) : (b) D/P (Dividend/ price ratio) and (c) D/P + g (Dividend /Price + growth rate of earnings ).
The E/P ratio assumes that since all the net earnings belong to owners, shareholders capitalize a stream of anticipated future earnings by the capitalization rate of E/P in order to evaluate their holding. According to this approach, therefore, the cost of equity is the ratio of earnings per share to market price per share. Many authors, however, feel that as a general rule; it is inappropriate to use E/P ratio as the cost of equity capita; because all earnings are not received directly by the share holders. It is only dividend what the shareholders are expected to receive on their investment and their return on investment depends by the corporate management. Thus, both from theoretical and practical point of view, there is a good case for using dividend evaluation model future dividends per share for measuring cost of equity capital, because dividend is a form of cash flow which is more consistent with capital budgeting decision.