Financial Management and Business Data Analytics · Cost of Capital

Cost of Equity Share Capital: Methods and Numericals

Updated 10 October 2026 · Fact-checked

Cost of equity is the return equity shareholders expect for bearing the risk of owning the company. You measure it with the dividend growth model (Ke = D1 ÷ P0 + g), earnings yield (E ÷ P), CAPM (Rf + β × (Rm − Rf)) or realized yield. For new issues, use net proceeds after floatation cost.

Understand Cost of Equity Share Capital

Equity shareholders get no fixed return and no promise of repayment. They still expect to be paid for the risk they take. That expected return is the cost of equity (Ke). For the company it is the minimum return it must earn on equity-funded projects so that the share price does not fall.

There is no interest or fixed dividend to read off, so Ke has to be estimated. Four approaches are asked in the exam.

Dividend price plus growth (Gordon) approach: the share price equals the present value of future dividends. If dividends grow at a constant rate g, then Ke = D1 ÷ P0 + g. It suits companies that pay regular dividends growing steadily.
Earnings price (earnings yield) approach: Ke = E1 ÷ P0, where E is earnings per share. It assumes the price reflects earnings and that earnings are fully paid out or do not grow. Use it only when the question points to it.
CAPM approach: Ke = Rf + β × (Rm − Rf). It links Ke to market risk. Only systematic risk, measured by beta, is rewarded.
Realized yield approach: Ke is the average return shareholders actually earned in the past (dividends plus price gain). It works only if past returns are a fair guide to the future, which is rarely fully true.

Some books also give a bond yield plus risk premium approach: Ke = yield on the company's long-term debt + a judgemental equity risk premium. Use it only when a question gives these inputs.

For new equity issues, the company receives less than the issue price because of floatation costs. So the denominator becomes net proceeds: Ke = D1 ÷ (P0 − F) + g. Retained earnings carry no floatation cost, so their cost is taken as the Ke of existing equity (see the retained earnings topic).

Key rules to remember

Dividend growth model (existing shares): Ke = D1 ÷ P0 + g, where D1 = D0 × (1 + g); D1 is next year's expected dividend. If the question gives D0 (dividend just paid), grow it by g first.
Cost of new equity issue: Ke = D1 ÷ (P0 − F) + g, or D1 ÷ NP + g; F is floatation cost per share; NP is net proceeds per share. Growth g is not adjusted for the cost.
Earnings yield: Ke = E1 ÷ P0 (new issue: E1 ÷ (P0 − F)); Use EPS, not DPS. Suitable when the question asks for the earnings price approach.
CAPM: Ke = Rf + β × (Rm − Rf); (Rm − Rf) is the market risk premium. If Rm is given, subtract Rf. If the premium is given directly, do not subtract again.
Realized yield: Yield for a year = (D + P1 − P0) ÷ P0; Ke = average of yearly yields; Use the average (arithmetic mean) of the yields unless the question asks for another method.
Bond yield plus risk premium: Ke = Yield on company's long-term bond + Risk premium; The risk premium is a judgemental figure given in the question.
Growth rate from retention: g = b × r, where b = retention ratio and r = return on equity; Use when g is not given but retention and ROE are.

How to solve Cost of Equity Share Capital questions

Pick the method from the data given. The question usually points to one approach by its inputs.

1Read the data and note the words used: dividend and growth, EPS, beta, past prices, or bond yield.
2Choose the method: dividend and growth gives Gordon; EPS and price gives earnings yield; beta and market return gives CAPM; a series of past prices and dividends gives realized yield.
3Find the missing input. If only D0 is given, compute D1 = D0 × (1 + g). If g is missing, use g = b × r or compute it from past dividends.
4Decide whether the issue is existing or new. For a new issue, subtract floatation cost from the price before dividing.
5Substitute carefully and compute. Keep percentages as decimals until the final step.
6Write the answer as a percentage, usually to two decimals, with the formula shown for step marks.
7If the question asks for a comment, add one line, for example that CAPM reflects market risk but Gordon relies on stable growth.

Quickest way: Spot the method from the inputs

When to use it: Use this for MCQs and for the first line of a written answer when time is short.

If you see beta, think CAPM: Rf + β × premium. Check whether the premium is already given.
If you see dividend and growth, compute D1 first, then D1 ÷ P0 + g.
If you see floatation cost, put it in the denominator only.
If you see EPS and price only, use E ÷ P.
Sanity check: Ke should be more than the cost of debt of the same company. If not, recheck.

Common mistakes in Cost of Equity Share Capital

Using D0 instead of D1 in the Gordon formula.
The question gives the dividend just paid and students plug it in directly.
Fix: Check the wording. 'Has just paid' or 'last dividend' means D0. Multiply by (1 + g) before dividing.
Subtracting Rf twice in CAPM.
The question states the 'market risk premium' and students still subtract Rf.
Fix: If the premium is given, use Ke = Rf + β × premium. Subtract only when Rm, the market return, is given.
Applying floatation cost to the growth rate or to the dividend.
Students adjust several figures to be safe.
Fix: Floatation cost reduces only the price: use P0 − F in the denominator.
Using DPS in the earnings yield approach, or EPS in the dividend approach.
Both are per-share figures and both appear in the question.
Fix: Dividend approach needs dividends; earnings approach needs EPS. Match the formula to the approach named.
Mixing percentages and decimals, such as 8 + 0.05.
Rushing under time pressure.
Fix: Convert all rates to decimals before calculating, then convert the final answer to a percentage.
Using the price after issue as the market price for a new issue without checking the question.
Questions may give issue price, market price and net proceeds together.
Fix: Use the price at which shares are sold, less floatation cost, unless the question says otherwise.

Worked examples

Example 1

Sunrise Ltd's equity share has a market price of ₹250. It has just paid a dividend of ₹20 per share, and dividends are expected to grow at 5% a year. (a) Find the cost of existing equity. (b) Find the cost of a new issue at ₹250 if floatation cost is ₹10 per share.

Show the solution

D0 = ₹20 and g = 5%, so D1 = 20 × 1.05 = ₹21.
(a) Ke = D1 ÷ P0 + g = 21 ÷ 250 + 0.05 = 0.084 + 0.05 = 0.134.
(b) Net proceeds = 250 − 10 = ₹240.
Ke (new) = 21 ÷ 240 + 0.05 = 0.0875 + 0.05 = 0.1375.

Answer: (a) Cost of existing equity = 13.40%. (b) Cost of new equity = 13.75%.

Example 2

Himalaya Ltd's equity beta is 1.2. The risk-free rate is 7% and the expected market return is 13%. The company's current EPS is ₹30 and its share price is ₹200. Find the cost of equity using CAPM and the earnings yield, and say why the two differ.

Show the solution

Market risk premium = Rm − Rf = 13% − 7% = 6%.
CAPM: Ke = 7% + 1.2 × 6% = 7% + 7.2% = 14.2%.
Earnings yield: Ke = E ÷ P = 30 ÷ 200 = 0.15 = 15%.
The two differ because CAPM uses market risk through beta, while the earnings yield uses only current earnings and price.

Answer: CAPM gives 14.2% and the earnings yield gives 15%. They differ because they rest on different assumptions.

Exam tips

MCQs are often one-step: spot D0 versus D1, or whether the premium is already given in CAPM. Read the data line twice.
In written answers, name the method, write the formula, then substitute. Step marks are given even if the final figure is off.
When the question says 'new issue' or 'floatation cost', expect the denominator to change, and attempt both parts.
For comparison questions, one line each on assumptions helps: Gordon needs constant growth, CAPM needs a reliable beta, and realized yield assumes the past repeats.
Show percentages to two decimals and keep working neat so the examiner can follow it.

Practice questions from Cost of Capital

Cost of Equity Share Capital 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: frequently asked questions

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

The dividend price approach uses expected dividends (D1 ÷ P0), with growth added in the Gordon version. The earnings price approach uses earnings per share (E ÷ P0). Dividends reflect what shareholders actually receive, while earnings include profit that may be retained.

How do I calculate cost of equity using CAPM?

Use Ke = Rf + β × (Rm − Rf). Find the market risk premium by subtracting the risk-free rate from the market return, multiply it by beta, and add the risk-free rate. If the premium is already given, use it directly.

Is cost of equity higher than cost of debt?

Usually yes. Equity holders bear more risk, with no fixed payment and a claim after lenders. Interest is also tax-deductible, which lowers the after-tax cost of debt further.

How is the bond yield plus risk premium approach used?

You add a judgemental risk premium to the company's own long-term bond yield. The premium is given in the question. It is a simple approximation when dividend or beta data are unreliable.

When is the realized yield approach used?

It is used when a question gives past prices and dividends and asks for the return shareholders actually earned. You compute each year's yield and take the average. It is reliable only if past returns are a fair guide to the future.