Financial Management and Strategic Management · Cost of Capital

Cost of Equity Share Capital: Dividend, CAPM and Earnings Models

Updated 4 October 2026 · Fact-checked

Cost of equity is the return equity shareholders expect for the risk they bear. You estimate it with the dividend growth model, Ke = D1 ÷ P0 + g, with the earnings yield, Ke = E1 ÷ P0, or with CAPM, Ke = Rf + β × (Rm − Rf). Pick the model from the data given.

Understand Cost of Equity Share Capital (Dividend, CAPM, Earnings Models)

Equity has no fixed payout and no maturity. Still, shareholders expect a return, and if the company fails to earn it, the share price falls. So cost of equity (Ke) is the minimum return the company must earn on equity-funded investments to keep the share price steady.

There are four common ways to estimate it. The dividend price approach says Ke is the dividend yield. If growth is expected, you use the dividend growth model (Gordon): Ke = D1 ÷ P0 + g. This treats the share price as the present value of a growing dividend stream.

The earnings price approach uses earnings yield: Ke = E1 ÷ P0. It suits firms that pay out all or most of their earnings, or where dividend data is not given. The realized yield approach uses the actual past return earned by shareholders, based on the assumption that the past will repeat.

CAPM looks at risk. Ke equals the risk-free rate plus a premium for market risk. The premium is beta times the market risk premium (Rm − Rf). Beta measures how much the share moves relative to the market. A beta above 1 means the share is riskier than the market.

CAPM is the only model here that explicitly prices risk. The dividend model needs a growth rate. Use the model whose inputs the question gives you.

Key rules to remember

Dividend price approach: Ke = D1 ÷ P0; D1 is the dividend expected at the end of year 1. P0 is the current market price. Use when dividends are constant.
Dividend growth model (Gordon): Ke = D1 ÷ P0 + g; Where D1 = D0 × (1 + g). Do not use D0 directly when the question gives the dividend just paid.
Growth rate from retention: g = b × r; b is the retention ratio and r is the return on equity. Use when g is not given and retention and ROE are.
Earnings price approach: Ke = E1 ÷ P0; E1 is expected EPS. If only current EPS is given, use it as stated unless growth is also given.
Realized yield approach: Ke = IRR of the cash flows: purchase price, dividends received and final sale price; Solve for the rate that makes the present value of the actual dividends and sale price equal to the purchase price.
CAPM: Ke = Rf + β × (Rm − Rf); Rm − Rf is the market risk premium. If the question gives only Rm and Rf, compute the premium yourself.
Cost of new equity (with flotation cost): Ke = D1 ÷ (P0 − F) + g; F is the flotation cost per share. It applies to new issues, not retained earnings.

How to solve Cost of Equity Share Capital (Dividend, CAPM, Earnings Models) questions

Use this method for any cost of equity question. Most marks go to choosing the right model and the right D1.

1Read the data and list what is given: price, dividend, EPS, growth, Rf, Rm, beta, flotation cost.
2Choose the model. If beta or market return is given, use CAPM. If dividend and growth are given, use the growth model. If only EPS and price are given, use earnings yield.
3Check whether the dividend is D0 or D1. If D0 is given with growth g, compute D1 = D0 × (1 + g).
4If growth is not given, see whether retention ratio and ROE are given, then compute g = b × r.
5If it is a new issue, reduce the price by the flotation cost. Use the net proceeds in the denominator.
6Substitute carefully and convert the result to a percentage.
7Write the formula first, then the working, then a one-line answer. This earns step marks.
8If the question asks for several methods, calculate each separately and state which is most suitable only if asked.

Quickest way: Pick the model from the data

When to use it: Use this in the MCQ section and as a first check in descriptive answers.

Beta in the question means CAPM. Compute Rf + β × (Rm − Rf) in one line.
Dividend and growth means Ke = D0 × (1 + g) ÷ P0 + g. Do the D1 step first.
Only EPS and price means Ke = EPS ÷ P0.
For MCQs, a quick estimate removes wrong options. For example, if D1 ÷ P0 is 8% and g is 5%, the answer must be 13%. Eliminate any option that is not 13%.
In written answers, always show the formula, the substitution and the final percentage. Even if the arithmetic slips, you keep the method marks.

Common mistakes in Cost of Equity Share Capital (Dividend, CAPM, Earnings Models)

Using D0 in place of D1 in the growth model.
The question gives the dividend just paid, and students plug it in directly.
Fix: Look for words like 'has just paid' or 'last dividend'. Then multiply by (1 + g) to get D1. Use 'expected dividend' as D1 as given.
Using the market return Rm as the premium in CAPM.
Students confuse Rm with Rm − Rf.
Fix: The formula needs (Rm − Rf). If the question says 'market return is 12%', subtract Rf first. If it says 'market risk premium is 6%', use 6% directly.
Forgetting flotation cost on new equity.
The same formula is used for retained earnings and new issues.
Fix: Check whether the question says 'new issue' or 'issue costs'. If so, use P0 − F. Do not apply it to retained earnings.
Treating earnings yield as always equal to cost of equity.
It looks simple, so students use it even when growth and dividends are given.
Fix: Use E1 ÷ P0 when the question points to it, or when it is the method asked for. Otherwise use the model the data supports.
Adding g to the CAPM result or ignoring beta.
Students mix the models while recalling formulas.
Fix: CAPM has no growth term. Keep the two formulas separate and write the formula before substituting.

Worked examples

Example 1

A company's share is quoted at ₹200. It has just paid a dividend of ₹10 per share, and dividends are expected to grow at 6% a year. Calculate the cost of equity using the dividend growth model.

Show the solution

Formula: Ke = D1 ÷ P0 + g.
D0 = ₹10 and g = 6%, so D1 = 10 × 1.06 = ₹10.60.
D1 ÷ P0 = 10.60 ÷ 200 = 0.053 = 5.3%.
Ke = 5.3% + 6% = 11.3%.

Answer: Cost of equity = 11.3%

Example 2

The risk-free rate is 7%, the expected market return is 13% and the beta of a company's share is 1.2. The share price is ₹150 and the expected EPS is ₹18. Calculate the cost of equity using (a) CAPM and (b) the earnings price approach.

Show the solution

(a) Market risk premium = 13% − 7% = 6%.
Ke = Rf + β × (Rm − Rf) = 7% + 1.2 × 6%.
1.2 × 6% = 7.2%, so Ke = 7% + 7.2% = 14.2%.
(b) Ke = E1 ÷ P0 = 18 ÷ 150.
18 ÷ 150 = 0.12 = 12%.

Answer: (a) Cost of equity by CAPM = 14.2%. (b) Cost of equity by earnings yield = 12%.

Exam tips

Underline words like 'just paid', 'expected' and 'new issue' in the question. They decide whether you use D0, D1 or flotation cost.
If both CAPM data and dividend data are given, calculate the method the question names. If none is named, state your choice and why in one line.
For MCQs, estimate first. Most options differ by a clear margin, so a rough calculation removes the wrong ones.
Write the formula, substitution and answer in separate lines in descriptive answers. This secures step marks.
Keep cost of equity linked with WACC. The result usually feeds into a WACC computation, so keep full precision until the end.

Practice questions from Cost of Capital

Cost of Equity Share Capital (Dividend, CAPM, Earnings Models) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Cost of Equity Share Capital (Dividend, CAPM, Earnings Models): frequently asked questions

Which model should I use for cost of equity in the exam?

Use the one the data supports. Beta and market return point to CAPM. Dividend and growth point to the growth model. EPS and price point to earnings yield. If the question names a method, use that one.

What is the difference between the earnings price approach and the dividend price approach?

The dividend price approach looks at the dividend the shareholder receives, adjusted for growth. The earnings price approach looks at total earnings per share against the price, whether or not they are paid out. They give the same answer only under special conditions, such as full payout with no growth.

How do I find the market risk premium in CAPM?

It is the expected market return minus the risk-free rate, Rm − Rf. Some questions give the premium directly, and then you do not subtract again.

Do I use D0 or D1 in the dividend growth model?

The formula uses D1, the dividend expected at the end of the coming year. If the question gives the dividend just paid, multiply it by (1 + g) first.