Corporate Accounting and Financial Management · Cost of Capital

Cost of Equity Share Capital: Methods, CAPM and Gordon Model

Updated 11 October 2026 · Fact-checked

Cost of equity (Ke) is the minimum return equity shareholders expect for the risk they bear. You can measure it by the dividend yield, Gordon growth model (Ke = D1 ÷ P0 + g), earnings yield, or CAPM (Ke = Rf + β × (Rm − Rf)). Pick the method that matches the data given.

Understand Cost of Equity Share Capital

Equity shareholders put money into a company and get no fixed return. They expect dividends and growth in the share price. The cost of equity is the return they require to stay invested. If the company earns less than this on equity-funded projects, shareholder value falls.

Unlike debt, equity has no stated interest rate, so we must estimate the cost. There are four standard approaches. The dividend yield approach looks only at the dividend against the market price. The dividend growth (Gordon) approach adds expected growth in dividends. The earnings yield approach uses earnings per share against the price. The CAPM approach builds the cost from the risk-free rate plus a premium for market risk.

The first three are based on the company's own dividends or earnings. CAPM is based on risk. It uses beta (β), which measures how much the share moves with the market. A beta above 1 means the share is riskier than the market and needs a higher return.

The key difference: the dividend growth model needs a reliable dividend and growth estimate, so it suits stable dividend payers. CAPM needs the risk-free rate, market return and beta, so it works even when a company pays no dividend. Equity is generally costlier than debt, because shareholders bear higher risk and have only a residual claim on the company. Interest is tax-deductible, so the after-tax cost of debt is lower still.

Key rules to remember

Dividend yield method: Ke = D1 ÷ P0; Assumes constant dividend with no growth, so D0 = D1 and you use the given dividend directly. P0 is the current market price. If the question gives the dividend just paid along with a growth rate, move to the growth model.
Dividend growth (Gordon) model: Ke = (D1 ÷ P0) + g, where D1 = D0 × (1 + g); g is the constant annual growth rate of dividends. If D0 is the dividend just paid, first compute D1.
Earnings yield method: Ke = EPS ÷ P0; Used when the market price reflects earnings rather than dividends. It treats the whole EPS as the shareholders' return and assumes no growth in earnings. If the question gives the EPS expected for next year, use that figure with the price; otherwise use the EPS given.
CAPM: Ke = Rf + β × (Rm − Rf); Rf is the risk-free return, Rm the expected market return, (Rm − Rf) the market risk premium. If the premium is given directly, use it as it is.
Net proceeds on new issue: Net price = Issue price − Floatation cost; For new equity shares, replace P0 with net proceeds: Ke = D1 ÷ NP + g.
Growth from retention: g = b × r; b is the retention ratio (1 − payout ratio) of earnings, and r is the rate of return on retained earnings. r equals the return on equity (ROE) only if the return on new investment equals the return on existing equity. The formula assumes a constant retention ratio and a constant return on retained earnings. Use it when g is not given directly.

How to solve Cost of Equity Share Capital questions

Use this method for any cost of equity question. The data given tells you which model the examiner wants.

1Read the question and list every figure given: dividend, price, growth, EPS, risk-free rate, beta, market return, floatation cost.
2Choose the method. Dividend and growth given: Gordon model. Only dividend: dividend yield. EPS and price: earnings yield. Beta or market return given: CAPM.
3Check whether the dividend given is D0 (just paid) or D1 (expected). If D0 and growth are given, compute D1 = D0 × (1 + g).
4Check the price. For existing equity use market price. For a fresh issue use net proceeds after floatation cost.
5Substitute into the formula and calculate carefully, keeping the decimals until the end.
6Convert the result to a percentage and state it as Ke.
7If asked, compare methods or state the assumption behind the model used, and write a one-line conclusion.

Quickest way: Data-first model selection

When to use it: Use this when time is short and the question gives numbers without naming the method.

Scan for the word beta or market return. If present, write Ke = Rf + β(Rm − Rf) and finish.
Otherwise scan for growth. If present, write Ke = D1 ÷ P0 + g, with D1 = D0(1 + g) only when D0 (the dividend just paid) is given. If the expected dividend D1 is given, use it as it is.
If no growth but EPS is given, write Ke = EPS ÷ P0.
If only a flat dividend is given, write Ke = D ÷ P0.
Underline whether the price is market price or net issue price before you substitute.

Common mistakes in Cost of Equity Share Capital

Using D0 directly in the Gordon model instead of D1.
The question gives the dividend just paid and students plug it in without growing it.
Fix: If the dividend is paid already, multiply by (1 + g) first. Use the dividend as it is only when it is stated as expected next year.
Using the market price for a new share issue and ignoring floatation cost.
Students memorise Ke = D1 ÷ P0 and forget that a new issue brings in less cash.
Fix: For a fresh issue, use net proceeds (issue price less floatation cost) in the denominator.
Using Rm instead of (Rm − Rf) in CAPM.
The market return is read as the premium.
Fix: Subtract Rf from Rm first, multiply by β, then add Rf.
Adding g to the earnings yield or CAPM result.
Students think growth must always be added.
Fix: Growth is part only of the dividend growth model. Earnings yield and CAPM do not add g.
Dividing the dividend rate (e.g. 15%) by the market price instead of converting it to rupees on face value first.
A dividend rate such as 15% is quoted on face value, so students divide the percent by price.
Fix: Convert the rate to rupees first: dividend = rate × face value, then divide by the market price.

Worked examples

Example 1

Shares of Sundaram Textiles Ltd. have a market price of ₹200. The company 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

D0 = ₹10 and g = 6%, so D1 = 10 × 1.06 = ₹10.60.
P0 = ₹200.
Ke = D1 ÷ P0 + g = 10.60 ÷ 200 + 0.06.
10.60 ÷ 200 = 0.053, so Ke = 0.053 + 0.06 = 0.113.

Answer: Cost of equity = 11.3%.

Exam tips

Write the formula first, then substitute. Marks are given for the method even if arithmetic slips.
State the assumption of the model you use, such as constant growth in dividends, in one line.
Check for floatation cost or a new issue price before you pick the denominator.
When asked to differentiate dividend growth model and CAPM, mention the data each needs and that CAPM works for non-dividend-paying companies.
Show the answer as a percentage with the working visible; round only the final figure.

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 growth model and CAPM?

The dividend growth model estimates Ke from the expected dividend, price and dividend growth. CAPM estimates Ke from the risk-free rate, the share's beta and the market risk premium. CAPM works even if no dividend is paid.

How do I calculate cost of equity using CAPM?

Compute the market risk premium (Rm − Rf), multiply by beta, and add the risk-free rate. For example, Rf 6%, β 1.5 and Rm 12% give Ke = 6% + 1.5 × 6% = 15%.

When should I use D0 and when D1 in the Gordon model?

Use D1 in the formula. If the question gives the dividend just paid (D0), find D1 = D0 × (1 + g). If the question says the expected dividend for next year, use it directly.

Does floatation cost affect the cost of equity?

It affects the cost of a new equity issue. Floatation cost reduces the net proceeds, so you divide D1 by net proceeds instead of the market price: Ke = D1 ÷ NP + g. This raises the cost of the new issue. The cost of existing equity, based on the market price, is not affected.