Concept Of Cost Of Ordinary Shares/Equity Shares Or Common Stock
The shares on which dividend rate is not predetermined and maturity period is not stated is called ordinary shares. Ordinary shareholders are the real owners of the company and they have the voting right. Ordinary shareholders receive the residual income i.e the income left after paying the interest to debt-holders and dividend to preference shareholders. Thus, the amount of dividend payable to ordinary shareholders is pre-determinable.
Since, the amount of dividend payable to ordinary shareholders is pre-determinable, the cost of ordinary share is calculated either on the basis of earning per share or by estimating the expected dividend on the basis of growth rate of past dividend.
Approaches Of Calculating Cost Of Ordinary Shares/Common Stock Or Equity Shares
Different approaches of calculating cost of ordinary shares or common stock or equity shares are as follows:
1. Earning Yield Approach
When the earning per share or net income after tax is given and there is no information regarding the dividend of ordinary share, the cost of ordinary share can be calculated on the basis of earning and market price of shares as shown below:
Ke = Earning per share/Market price per share or, EPS/MPS or, EPS/NP
2. Dividend Yield Approach
When the dividend per share or total equity dividend is given and there is no information regarding the growth rate, the cost of equity share can be calculated on the basis of dividend and market price of shares as below:
Ke = Dividend per share/Market price per share or, DPS/MPS or, D/NP
3. Dividend Yield Plus Growth Rate Approach
This is the most popular method of calculating the cost of equity shares. Under this method, the cost of equity share is determined on the basis of the following information:
i. Current Dividend(Do): The dividend which has been recently paid and referred as last year's dividend, previous dividend, past dividend etc.
ii. Growth Rate In Dividend (g): The rate at which the annual earning or dividend is increasing. When the growth rate is not given, it can be computed on the basis of past dividend or earning.
iii. Expected Dividend (D1): The dividend which will be paid to the shareholders in the recent future is called expected dividend. It is also referred as next dividend, coming dividend, future dividend, subsequent dividend etc. On the basis of current dividend and past growth rate, the expected dividend can be determined as below:
Expected dividend = Current dividend(1+ growth rate) or, D1 = Do(1+g)
iv. Net proceed Or Net Market Price (NP): The net selling price of share after deducting all kinds of issuing expense is known as net proceed. The expenses incurred in the process of issuing the shares is called flotation cost. Flotation cost includes brokerage fee, commission and other publicity and administrative expenses. Net proceed is determined as follows:
Net proceed (NP) = Gross selling price - Flotation cost
= Gross selling price(1-Flotation cost) = Po(1-f)
On the basis of the above information, the cost of equity shares can be calculated as given below by using dividend yield plus growth rate approach:
Ke = (D1/NP) + g = Dividend yield plus Growth rate
