# Cost of equity - Corporate financial management

## Cost of equity

Although the investor has the opportunity to receive income on his shares in the form of a dividend or an increase in their market price, the increase in the rate (price) is ultimately explained by the proceeds that will be paid out for the stock, i. future dividends. Therefore, the required level of profitability on the part of the investor in any case for the issuer is the value it pays (sooner or later) for using equity capital. When determining the cost of equity, not only dividends should be taken into account, but also the expected average annual increment of the share price in the future.

The cost of capital according to BCM. Suppose we are talking about a company that is growing steadily over an infinite period of time. Its price is well described by Gordon's model:

Using this (DCM), model, you can estimate what rate the corporation pays for using share capital of shareholders. Indeed, the model shows what price to pay for the share, in order to get a profitability level equal to to. However, if we resolve this equation with respect to k, we get an answer to the question: what rate of return is paid to investors by the issuing corporation for its shares that have a market the value of P, the expected dividend in the current period DPS and the average annual dividend gain g.

Case : by assumption, the capital received from the placement of common shares is estimated at RUB 8013 mln, the placement occurred at a par value of 1,000 rubles. for the share expected in the current period dividend (DPS) - 244.5 rub. per annum, the average annual increase in the dividend (g) - 6% per year. Current market rate (P) - 2000 rub. per share.

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Therefore, in all, 8013 thousand common shares (8013 million rubles: 1,000 rubles per share) were issued.

Calculate the cost of capital received from their placement:

The market value of all these shares (capitalization) in the amount of 16 026 million rubles. (8013 thousand shares x 2000 rubles per share).

The capital received through the placement of irrevocable preferred shares, according to the balance sheet valuation is equal to 2,165 million rubles. The placement took place at a par value of 1,000 rubles. for a share, a fixed dividend rate of 17% per annum, the current market rate (P) - 1050 rub. per share. The dividend for these shares is fixed, therefore, g = 0:

We calculate the number of these shares in circulation: 2165 million rubles: 1000 rubles. per share = 2165 thousand preferred shares.

Their market capitalization will be 2273 million rubles. (2165 thousand shares x 1050 rubles per share).

The cost of equity capital according to CAPM. In the previous chapter, we also got acquainted with another way of estimating the cost of equity capital. The level of profitability required by investors can be determined in accordance with the state of the financial market and the degree of systematic risk quantified by the coefficient p:

The user can easily obtain input data for estimating the cost of the United States company's equity by the CAPM method (address: finmanager.ru, section "Consultations").

Case : According to the condition, the following source data is known:

o rate of return with a minimum risk of 5% per annum;

o The average annual growth of the stock index - 18% per annum;

o systematic risk factor | 3 for corporation 1.07.

Knowing these data, it is not difficult to determine the level of profitability required by the holders of common shares (which is also the cost of the corporation's capital received from the placement of these shares):

As you can see, estimates of the cost of equity on the basis of the models DGM and CAPM give different results. Is it natural?

CAPM and DGM - comparison of models for estimating the cost of equity. In fact, it is difficult to expect that two different methods of estimating the value of the corporation's equity capital will yield the same result. The nature of these models is different, and the assumptions underlying them are also different.

First, the DGM model is positive, and the model CAPM - is normative. This means that DGM is based on actually expected dividend estimates and its growth by given corporation, and CAPM expresses average market requirements relative to investments at a given risk level . Thus, using the DGM model to estimate the cost of capital already assumes that the company is adequately priced by the market and its actual expected return corresponds to the required yield.

Secondly, DGM- a model based on the discounting of dividends over an infinitely long period of time, and CAPM expresses the current market requirements for one time interval.

Third, in terms of accuracy and correctness of estimates, the CAPM model is considered preferable, since it is difficult to estimate the future size of the dividend and its growth rate, only with a large we can say that the increase in the dividend for years can be a constant g. Finally, when assessing the level of profitability required by investors, it is more correct to base on market requirements, rather than on actual expectations.

The value of capitalized profits. In addition to external sources of equity financing, the corporation has an internal source - the reinvested profit of the enterprise. At first glance, it may seem that this is a free source, since it is not directly related to financial markets and their requirements. However, in the end, the profit belongs to the corporation, to be more precise, to its shareholders who hold common shares. It was their decision at the general meeting that led to the fact that the money was invested in the enterprise, and not directed at paying dividends. Therefore, the profit not distributed to dividends should also be considered as capital, which the shareholders expected to satisfy their claims on the level of profitability. The value of this capital, therefore, will exactly coincide with the cost of capital received from the placement of common shares. In more detailed calculations, one can take into account that when placing common shares, the corporation is going to additional costs associated with the registration of a new issue and underwriting. With the mobilization of domestic sources of capital, these costs are not available, therefore, taking into account transaction costs, capital from the placement of shares has a slightly higher cost than retained earnings.

In determining market capitalization, we multiplied the number of shares issued into circulation at their market price. The market price of common shares is a market valuation not only of their nominal value, but also of the capitalized profit per one common share.

Case: calculate the cost of equity (equity) capital for the corporation "N-Energy". To this end, we will compile a table (Table 4.3).

TABLE 4.3. Characteristics of the shares of the corporation "N-Energy"

 Shares Market capitalization, million rubles Cost of capital,% per annum Simple 16,026 18.91 Preferred 2273 16.19

The cost of equity capital is equal to the weighted average value of the cost of capital of each component:

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