A firm may face a situation where it needs to raise funds by issue of fresh equity capital in order to finance the new project. If so, then what return must be earned on these funds raised by fresh issue to make the project worthwhile. The existing equity share capital expect the firm to pay a stream of dividends and this stream of dividends is earned from existing assets. The new equity capital will also likewise expect to receive the same quantum of returns. Obviously, for new share to obtain the same stream as that on existing share s, the new funds obtained from the issue of fresh capital must be utilized to produce a return high enough to provide a dividend stream whose present value is just equal to the net proceeds of fresh issue. In other words, the minimum rate of return which the new shares expect in order to prevent a decline in the market price of existing shares , is the cost of fresh equity.

Theoretically speaking, the firm should therefore, sell the new shares at the current market price of existing equity shares. However, in practice, the net proceeds to the firm will be reduced as the firm will be required to bear additional expense of floatation including underwriting expenses, brokerage, issue expenses, advertisement and above all a discount off the current price to the potential investor to induce them to subscribe all the shares offered. Thus, the net proceeds will be reduced below the current market price for

i)    The floatation cost.
ii)    Offer price being below the current market price.

The cost of new equity shares can be estimated on the basis of equation by determining the net proceeds after floatation cost etc., and taking the assumption of constant growth rate as follows:

                  k _n  = D₁   / NP    +   g


where   NP =  Net proceeds from fresh issue
             k _n  =  Cost of new equity
             D ₁ = Expected dividend at the end of year  1
              g   =  Growth factor

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