Cost of Equity

If we talk about computing cost of debt and cost of preference share is comparatively an easier task, because cash-outflows in respect of interest or dividend are fixed and obligatory (at least in case of interest on debt). In case of equity capital neither the rate of dividend is fixed nor is it obligatory or legal binding on the company to pay dividend. That is why, some people may have the impression that equity capital does not involve any cost. But such an impression will be far from truth.
In fact, equity capital also involves cost by implication, because the shareholders expect from the management, fulfillment of certain expectations in respect of their investment in such shares. These expectations are that the management will earn at least that return on their capital which will provide them the following:
A regular stream of earnings per share (EPS).
A regular stream of dividend per share (DPS).
Growth in their future EPS and DPS through gradual increase in retained earnings.
The third expectation is as important as the first two, because accumulation of retained earnings (which virtually belong to equity shareholders) has a crucial impact on the growth of future EPS and DPS and consequently on the maximization of market value of investment in equity shares of the company.
Thus, it can be inferred that a company must fulfill the above expectations of its equity shareholders by earning at least that minimum rate of return, on their investment which will at least maintain the existing EPS and DPS and the market value.