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Cost of Equity Capital Calculation Methods

Cost of Equity Capital Calculation Methods. Market determined standard Comparable earnings standard. Market determined standard. Earnings-price ratio Cost of equity capital is equal to the ratio of current earnings per share to the market price per share Discounted cash flow model (DCF)

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Cost of Equity Capital Calculation Methods

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  1. Cost of Equity Capital Calculation Methods • Market determined standard • Comparable earnings standard

  2. Market determined standard • Earnings-price ratio • Cost of equity capital is equal to the ratio of current earnings per share to the market price per share • Discounted cash flow model (DCF) • Formula is (d/p) + g • d is current dividend per share • p is current market price per share • g is expected rate of growth in dividends per share

  3. Market determined standard (cont.) • Capital Asset Model (CAPM) • Formula is Rf + (Rm – Rf)β • Rf is risk free return • RM is expected return on a stock market portfolio • Β is the beta coefficient (company’s relevant market risk)

  4. Comparable earnings standard • Based on the idea of opportunity cost • “capital should not be committed to any venture unless it can earn a return commensurate with that prospectively available in alternative employments of similar risk.”—testimony regarding Tampa Electric Co by S. F. Sherwin. • Examine earnings on common equity for enterprises with similar risk, or with different risk with allowance for risk differences

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