Question 4 (a)

Approaches to calculating the cost of equity

4 marks

Time to write
About 8 minutes

From an older CBCS paper

Question

Question 4 (a) · 4 marks

What are the different approaches to calculating the cost of equity ? 4

Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.

Before you write

Read off the question and its marks

8 minfor 4 marks

Read from the question

  • What areThe meaning first, then the main points.

What the paper leaves open

The question is partly within the current syllabus; the answer covers the approaches the syllabus names.

Write it in this order

  1. Read; underline the asks; jot your points 1 min
  2. 1 Meaning of the cost of equity ½ mark 1 min
  3. 2 Dividend yield and dividend growth methods 2 marks 3 min
  4. 3 Earnings yield and CAPM 1½ marks 3 min

Easy marks

  • Meaning of the cost of equity (step 1, ½ mark): a definition in one or two lines. It opens the answer, so it takes a minute or two.

Short on time? Keep step 1 short. Trim steps 2 and 3 evenly rather than skip one: each is capped at its own marks.

Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.

Solution

Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.

The cost of equity is the rate of return the company must earn on the equity-financed part of its investments; it is a function of the return its investors expect. It is not a fixed, legally binding payment, but equity is not cost-free. The approaches are:

  1. Dividend yield (dividend–price) method: Ke = D ÷ NP (new issue) or D ÷ MP (existing shares): the rate that equates the expected dividends with the net proceeds or market price. Suitable when dividends are stable.
  2. Dividend yield plus growth (Gordon) method: Ke = D1 ÷ NP + g, or D1 ÷ MP + g for existing shares, where g is the constant growth rate of dividends. Used when dividends grow at a steady rate.
  3. Earnings yield method: Ke = EPS ÷ NP (or ÷ MP). Appropriate when earnings are stable and all are paid out, or the price reflects earnings.
  4. Capital asset pricing model (CAPM): Ke = Rf + β(Rm − Rf), the risk-free rate plus a premium for the share's systematic risk.

Where the 4 marks sit

#ComponentMarks
1Meaning of the cost of equity0.5
2Dividend yield and dividend growth methods2
3Earnings yield and CAPM1.5
Total4
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