Cost of Equity and Other Valuation Methods for Desklib

Table of Contents
Cost of Equity and Other methods........................................................................................................2
Valuation methods of the business.......................................................................................................5
Theories of capital structure..................................................................................................................6
References.............................................................................................................................................8

Cost of Equity and Other methods
a) The rate at which any enterprise earns a considerable amount of return on investment(ROI)
so that the market value is maintained and the funds are attracted . When a company raises
capital, it has to incur some annual maintenance cost. The effective annual cost after tax is
called cost of capital (Belton, 2017).
There are seven methods of estimating the cost of capital which are here as under:
1. Cost of Debt Capital(Kd)
The cost of long term debt excluding the cost of short term debt assuming that the short
term debt does not play an important role in the determination of the cost of debt or the
short term receivables compensates for the interest paid on short term debt helps in
calculating the cost of debt. It affects the taxation policy of the firm (Bizfluent, 2017).
Cost of Debt is always computed after tax because interest payments are
adjusted by the deduction of tax for the firm. It is denoted by the term Kd.
Kd after taxes = Kd (1-tax rate)
If the Cost of Debt is issued at Discount:
Kd = interest rate( 1-tax rate) / sale value
If the cost of Bond/Debentures are redeemable after a certain period:
Kd (before tax) = (I+ [RV-SV] / n) / (RV + SV) /2
Where:
I= Annual fixed interest
RV= Redeemable Value of debenture net of commission and floatation
costs, if any
SV= Sale value of debentures net of discount or premium
N= Term of debt till maturity
Kd (after tax) = Kd(before tax) * (1-T)
2. Cost of Preference Capital
Being almost similar to that of debenture and bonds, a rate is fixed for the
dividends of preference shareholders and it is distributed on priority basis
before any other shareholders. The dividends of these shareholders are
not taxable. Preference shares are redeemable as well as irredeemable
(Bennuona, et al., 2010).
If the cost of preference capital is redeemable:
Kp = Annual dividend of preference shares
Market price of preference stock
If the cost of preference capital is irredeemable:
Kp= D+ (RV-SV) /N
(RV+SV) /2
Where, Kp= cost of preference share capital
RV= redemption value
SV= sale value

N= no. of years to maturity
D= Annual Dividend
3. Cost of Equity Capital
The money which is invested by the investors also the promoters of the firm determines the
cost of Equity (Choy, 2018). The return on investments earned in terms of dividends. The
various ways to calculate the cost of equity are:
 CAPM model
The first is the most oldest way to calculate the cost of equity. The return rate
at which the cost of equity capital is determined.
Ke = Krf + Beta (Km-Krf)
Where,
Ke= cost of equity
Krf = Risk-free rate
Km = Equity market required return (expected return on the market portfolio)
beta =Systematic Risk Coefficient.
 Bond Yield Plus Risk Premium Approach
This is a way which is precise enough to calculate the cost of equity. In this approach
a amount of premium related to risk is added to the return which is derived from the
long term bonds or debentures.
Cost of equity = Yield on long-term bonds + Risk Premium.
 Dividend Growth Model Approach
The cost of the equity is dependent entirely on the dividends which are earned by
the shareholders.
r = D1/P0+ g
where: P0 = Current price of the stock
D1 = Expected dividend at the end of year 1
t = Year t
r = Equity shareholders' required rate of return
 Earnings-Price Ratio Approach
This way shows the formula as :
Ke = E1 /P0
Where: E1 = Expected earnings per share for the next year
P0 = Current market price per share
E1 = (Current EPS) * (1 + growth rate of EPS)
4. Weighted Average cost of capital
WACC is calculated taking all the average of the weights using the book
value weights and the market value weights. It can use any of the values
as weights to determine the same (Sonu, et al., 2017).
Weighted Average Cost of Capital = (KE * E) + (KP * P) + (KD * D) + (KR*
R)
Where,