The cost of debt capital (as well as preference capital) can be calculated fairly easily. This is because it entails a well-defined burden in terms of interest payment and principal payment. Estimating the cost of equity capital, however, is difficult as there is no fixed dividend or principal payment burden associated with it. Equity dividend is payable out of the earnings of the firm at the discretion of the board of directors. Further, the question of repaying the equity capital does not ordinarily arise during the life of the firm. In liquidation, of course, equity shareholders are entitled to the residual assets of the firm.
Theoretically, the cost of equity is the discount rate which equates the present value of the future dividends to the net amount realized from the issue of equity capital. While it is almost impossible to predict the future dividends, it seems reasonable to assume that dividends would grow over time because firms generally reinvest a significant portiorr-40 to 60 percent of their earnings. Such reinvestment tends to enhance future earnings and dividends. Hence the cost of equity may be calculated as follows
Cost of equity = (Expected dividend per share/ Net price realized from issuing an equity share) + Expected annual rate of growth in dividends
(The formula for cost of equity presented here is derived from equating the present value of a dividend stream which is expected to grow at a constant rate with the present market price per share)
As you may have guessed, the difficulty in applying cost of equity formula arises mainly with respect to estimating the growth factor. One can begin with the past growth rate as a starting point. Past trends, however, cannot be expected to continue indefinitely in future. Hence the past growth rate figure will have to be adjusted in the light of assessments regarding future developments. Clearly, there will be varying judgments with respect to future growth. Yet, such a judgment is essential in order to get a handle over cost of capital.
If we assume that the expected annual rate of growth in dividends for Horizon Limited is 10 per cent, we get the following estimate for its cost of equity: