Question

List and describe each of the three methods used to calculate the cost of common stock.

Answer 1

Methods to calculate the cost of common stock/equity are as follows:

1.) CAPM (Capital Asset Pricing Model) Approach - According to CAPM approach,cost of equity is calculated as

Cost of equity = R_f + _E[E(R_m) - R_f]

where R_f = Risk free rate

  E = Beta of the Equity

E(R_m) =  Expected return on the market portfolio

CAPM Approach includes the unstable Beta of individual securities which is a flaw associated with this approach but still maximum MNCs use this approach.

2.) Dividend Growth Model Approach - This model is applicable to companies that pay dividend and also listed on the stock market.It is calculated out of the current price of the stock assuming a constant growth in the dividends. Calculated as,

R_E = Cost of Equity

D₁ = Dividend expected to be paid at the end of the year

P₀ = Current price of the stock

g = Expected growth rate

D₁ can also be calculated as D₁ = D₀(1+g) where D₀ = Dividend at the beginning of the year.

3.) Bond yield plus Risk Premium Approach - This approach is generally used where cost of debt is high consequently resulting to higher cost of equity due to high risk involved,calculated as :

Cost of Equity = Yield on long term bonds + Risk premium