## January 7, 2013

### IB0010 [International Financial Management] Set1 Q3

3. Briefly explain how an MNC can calculate its cost of equity capital.

Ans.

The cost of equity capital
The cost of equity capital is the required rate of return needed to motivate the investors to buy the firm’s stock.  Calculation of th cost of equity is a difficult process and needs more approximations than calculating the cost of debt.  For established firms, the dividend growth model may be used for computing the cost of equity.  This model is also called the Gordon model.
Ke=   D1/Pq+ g
Where,    Ke is the cost of equity capital
D1 are Dividends expected in year one.
Pq is the current market price of the firm’s stock
G is the compounded annual rate of growth in dividends or earnings

Alternatively, the cost of equity capital may be calculated by using the modern capital market theory.  According to this theory, and equilibrium relationship exists between an asset’s required rate of return and its associated risk which can be calculated by the Capital Assert Pricing Model (CAPM).

The cost of equit5y may be calculated by the CAPM by using the following formula
E(Rj) = Rf + Bj(E (Rm) – Rf)

Where E (Rj) is the expected rate of return on asset j. Rf is the rate of return on a risk free asset measured by the current rate of return or yield on treasury bonds.

E (Rm) is the expected rate of return on a bond market index such as the standard and poor index of industrial stocks.

Bj is the beta of stock j, measured by the relative variability or volatility of the rate of return on the stock compared to the variability of the return on a broad market index.  A beta of 1 (unity) denotes a risk equivalent to the one entailed in an investment in a diversified portfolio of stocks.

Both, the Gordon Model and the CAPM, yield a risk adjusted rate of return on equity.  The major difference is that the latter utilizes beta which is a measure of the market related or systematic risk rather than total risk which is traditionally measured by the standard deviation.  Both methods yield acceptable and conceptually defensible estimates of the rate required by the investors given the degree of risk inherent in the investment.  For firms with no established track record and for which beta coefficients are not available, the cost of equity may be derived by adding an arbitrary risk premium (ranging between four to six percentage points) to the firm’s recent borrowing rate.