(165)---COST OF EXTERNAL EQUITY: DIVIDEND GROWTH MODEL

Cost of External Equity: Dividend Growth Model

The firm’s external equity consists of funds raised externally through public or rights issues. The minimum rate of return, which the equity shareholders require on funds supplied by them by purchasing new shares to prevent a decline in the existing market price of the equity share, is the cost of external equity. The firm can induce the existing or potential shareholders to purchase new shares when it promises to earn a rate or return equal to:

Ke = (DIV 1 / Po) + g

Thus, the shareholders’ require rate of return from retained earnings and external equity is the same. The cost of external equity is, however, greater than the cost of internal equity for one reason. The selling price of the new shares may be less than the market price. The new issues of ordinary shares are generally sold at a price less than the market price prevailing at the time of announcement of the share issue. Thus, the formula for the cost of new issue of equity capital may be written as follows:

Ke = (DIV 1 / P 1) + g

Where P 1 is the issue price of new equity. The cost of retained earnings will be less than the cost of new issue of equity if P0 > P1.