An Assignment On

COST

OF EQUITY

Prepared By Kritagya Dubey (GD-037) Hemant Goyal (GG-035) Joshua Prakash (GP-067) FY MBA Submitted To Kumunidhi Maam METAS of Seventh Day Adventist College Athwalines, Surat Affiliated to North Eastern Hill University Surat For Academic Year 2010-2011

What is Equity?
Ownership interest in a corporation in the form of common stock or preferred stock. It also refers to total assets minus total liabilities, in which case it is also referred to as shareholder's equity or net worth or book value. In real estate, it is the difference between what a property is worth and what the owner owes against that property (i.e. the difference between the house value and the remaining mortgage or loan payments on a house). In the context of a futures trading account, it is the value of the securities in the account, assuming that the account is liquidated at the going price.In the context of a brokerage account, it is the net value of the account, i.e. the value of securities in the account less any margin requirements. Equity capital generally is composed of funds that are raised by a business in exchange for an ownership interest in your company. This interest can be in the form of ownership of common or preferred stock or instruments that convert into stock. In addition to taking an ownership interest in your company, equity investors may also participate as a member of the companys board of directors and take an active role in managing your company. Equity represents shares. one share is equal to one unit of capital employed in the business

Following are the Features of equity shares:

1. They don't have no preferential right in respect of payment of dividend or in the repayment of capital at the time of winding of the company. 2. Equtiy shares are risk bearing shares because they are the actual owners of the company when ever company run into losses they have to bear the losses. 3. Equity share holders enjoys voting right whenever there is a meeting they will enjoy their voting power, enjoys voting power in electing board of directors. 4. Equity capital is the permanent capital for the company. The companies need not to return capital. Company has to repay the capital only at the time of winding up. 5. Equity shares are easily transferred from one person to another at the stock exchange according to the procedure laid down in the article of association of the company. 6. Company gives the bonus shares to the equity shareholders at a free cost on account of reserves. Undistributed profits and accumulated profit 7. Equity shareholder are give first priority when ever company want to raised fresh capital

Cost of Equity:
Equity finance may be obtained in two ways: Retention of earnings Issue of additional equity.

The cost of equity or the return required by equity shareholders is the same in both the cases. Remember that when a form decides to retain earnings, an opportunity cost is involved. Shareholders could receive the earnings as dividends and invest the same in alternative investments of comparable risk to earn a return. So irrespective of whether a firm raises equity finance by retaining earnings or issuing additional equity shares, the cost of equity is the same. The only difference is in floatation costs. There is no floatation cost for retained earnings whereas there is a floatation cost of 2 to 8 percent or even more for additional equity. So, in our present discussion, cost of equity refers to the cost of retained earnings as well as the cost of external equity.

While the cost of debt and preference can be determined fairly easily, the cost of equity is rather difficult to estimate. This difficulty stems from the fact that there is no definite commitment on the part of the firm to pay dividends. However, we can come up with reasonable good estimated of the cost of equity by employing some basic principles.

Definition:
COST OF EQUITY (COE) is the minimum rate of return a firm must offer owners to compensate for waiting for their returns, and for bearing risk. It is calculated: COE = Dividends per Share (for next year) / Current Market Value of Stock + Growth Rate of Dividends. Cost of equity capital is acknowledged as the rate of return that is necessary to satisfy commitments made to the common shareholders of a corporation. Generally, the cost of equity capital is expected to be equal to the rate of return that is expected on equity-supplied capital. The basic formula for calculating the cost of equity capital involves a few simple figures that are easily extracted from the financial data relevant to the period cited. In order to determine the cost of equity capital, it is necessary to know three specific figures. First, the current market value associated with the shares must be determined. Second, the dividend growth rate as it relates to the period under consideration must be calculated. Last, the number of dividends per share should be identified. Once these three pieces of information are in hand, it is possible quickly calculate the current cost of equity capital. The basic formula for cost of equity capital begins with dividing the dividends per share by the current market value. The resulting figure is added to the dividend growth rate. After adding the two figures, the cost of equity capital as it relates to the shares is revealed, and can be reported to the shareholders.

Companies tend to use this basic formula on an ongoing basis, taking into account any new data that may have come to light since the previous financial period. Monitoring the cost of equity capital is one of the tools that is used to make sure that the shareholders are protected, and also that the best interests of the company are served. Because the formula is so simple, the harder part of the process is to gather the needed data. However, once the figures are in hand, it takes no time to determine the current cost of equity capital. Investors who are able to access the three basis figures needed to calculate the cost of equity capital can also make use of this simple formula as well. The data needed is often included in financial reports to investors, or can be obtained by speaking with financial analysts. As a quick and easy way to check on the status of the shares, the cost of equity capital does in an indirect way help to ensure the investor that the shares are being managed properly and the investment remains sound.

How

to Calculate the Cost of Equity Capital:

Cost of equity is the return a company must offer investors to entice them to invest in the company. The cost of equity is a return percentage a company must offer investors to spark investment in the company. This is an important measure, because an investor will only invest if he believes he will receive his desired rate of return. Managers also use this measure to calculate weighted-average cost of capital (WACC). WACC calculates the average cost the company needs to pay to raise capital through equity and debt.

Instructions
1. Find the current market value per share of stock. This is the amount the stock is currently being bought for on the open market. Estimate a projected dividend amount the company will pay next year. The project dividend amount is an estimate investors will make based on previous dividends. For example, if a company always pays $1 per share of dividends each year, an investor would project dividends to be $1 a share for next year. Determine the dividend growth rate for the company. As this calculation can become complicated, the dividend growth rate is normally disclosed by the company or calculated on investment sites. For example, a company projects to pay $1.50 in dividends next year. The current

market price per share is $20. The dividend growth rate of the company is 4 percent.

2. Divide the projected dividends for next year by the current market price per share. In the above example, $1.50 divided by $20 equals 0.075, or 7.5 percent. 3. Add the dividend growth rate to the number calculated in Step 2 to calculate cost of equity. In the above example, 4 percent plus 7.5 percent equals 11.5 percent.

References:
www.allinterview.com www.investorwords.com www.wiki.answers.com www.indiastudychannel.com www.theequitydesk.com