Cost of Equity
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456175_1_module-slp.docxRisk and return, portfolio diversification and the Capital Asset Pricing Model; The cost of equity
The Cost of Equity
In this section of the Session Long Project you will estimate the cost of equity or the rate of return that your company's shareholders “require.” This is a vital piece of information: Every top manager must be able to estimate this because it will be an important input in determining whether any particular course of action will or will not add value for the shareholders.
We are going to use the Capital Asset Pricing Model (CAPM) to estimate the rate of return that our shareholders require on their investment. This is the minimum rate of return that these shareholders require. As stated above, we call this rate “the cost of equity” and it is expressed in percentages or in a decimal format.
The CAPM states the following equilibrium relationship between the (excess) rate of return that shareholders of a particular company "j" require (or actually in some sense “deserve” if they fully diversify their investments) and the (excess) expected rate of return on the market portfolio:
Rj - RF = βj [RM - RF]
E(rj) - The cost of equity
RF - Risk-free rate of return
ßj - Beta of the security
RM - Return on market portfolio
It follows that the rate of return that shareholders require or expect to earn on their investment in the shares of the company, or “the cost of equity” is:
Rj = RF + βj [RM - RF]
Assignment Expectations
To estimate the cost of equity for your company, obtain an estimate of the company's “beta” or systematic risk coefficient, on the annual rate of return on a risk-free investment, and on the expected rate of return on the “market portfolio.” You can easily find that information by going to the following web site: http://finance.yahoo.com and inserting the name of your company. The beta of the company is reported on that website.
Click on the "Key Statistics" link on the left-hand side of the screen to find the beta and other information.
First find out what is the present Yield to Maturity (YTM) on a U.S. Government bond that matures in one year or 13 weeks Treasury Bill Rate [ http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield ]. That rate is the “risk-free rate.”
Next, it is customary to assume that the difference between the expected rate of return on the “market portfolio” and the risk-free rate of return is about 5.0%. This is the expression [RM - RF]. For example, if the risk-free rate of interest is 1% per year, the expected rate of return on the “market portfolio,” RM, is 6%. Multiply the “beta” of your SLP company by 5.0%. That will be the equivalent of your company's βj [RM - RF]. Add to that number the current yield to maturity on a U.S. Government bond (see previous paragraph). You are free to try to research and find more up-to-date values of RM and RF, but to simplify this assignment you can also assume that RF = 1, RM =5 and [RM - RF]= 4.
The above procedure provides you with an estimate of the rate of return that the shareholders of your SLP company require on their investment. This rate is called the cost of equity of your company.
After going through these calculations, write a 2 to 3 page paper with the following information:
1) Show the work you did to obtain the cost of equity for Starbucks company.
2) Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 8.2 percent. Would you think your firm should have a lower or a higher cost of capital than the average firm?
3) Look up the betas for McDonald and Yum Brands. These are the companies that you had to explain had a higher or lower discount rate than Starbucks Company. Using these betas, compute the cost of equity for these firms. How do they compare to Starbucks Company? Are you surprised that some firms have a higher or lower cost of equity than Starbucks Company?
You can find company beta by using the website http://ca.finance.yahoo.com/ . For example, you want to find beta of General Electric Company. Key in company code “GE” and then click on “Key Statistics” ( http://ca.finance.yahoo.com/q/ks?s=GE ). You will be able to find beta of the company.
4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for Starbucks Company? You do not have to do any calculations; just explain how you would go about doing these calculations and explain what kind of additional information you might need.
5) What do you perceive you have learned in this Module? Which of the following learning outcomes do you feel you have mastered?
· Apply the CAPM to estimate the cost of equity of a publicly traded company, or the rate of return that its investors require.
· Understand and explain arbitrage pricing theory and its relationship to the CAPM and dividend growth model.
· Explain the possible application of the dividend growth model and apply it to estimate the implicit cost of equity of a mature, stable company.
Provide a brief evaluation of this Module.
Note: Please make sure to use the proper citations and references. You must use the sources from the background material together with the sources you find on your own. It is also required that you answer all the questions related to learning outcomes.
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Background Materials
Dividend Growth Models
Investopedia.com (2012). The Gordon growth model. Retrieved May 2012 from http://www.investopedia.com/terms/g/gordongrowthmodel.asp
The following reading, though not recent, is still useful:
Pages.stern.nyu.edu (n.d.). Dividend discount models. Retrieved May 2012 from http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf
The following reading, though not recent, is still useful to understand the dividend growth model:
Clark, T. (2000). Earnings growth and stock returns. Retrieved May 2012 from http://www.dfaus.com/library/articles/earning_growth_stock/
Capital Asset Pricing Model
Investopedia.com (2012). Financial concepts: capital asset pricing model (CAPM). Retrieved May 2012 from http://www.investopedia.com/university/concepts/concepts8.asp
This Article on Investment Analysis is a highly comprehensive overview on measuring risk and the use of the CAPM. This article is a good place to start because it will give you an idea of how the CAPM is used in the "real world" as well as demonstrate the basic concepts of this module.
Valuebasedmanagement.net (2012). Capital asset pricing model (CAPM). Retrieved May 2012 from http://www.valuebasedmanagement.net/methods_capm.html
The following Wikipedia article may also be useful to understand CAPM model:
En.wikipedia.org (2012). Capital asset pricing model (CAPM). Retrieved May 2012 from http://en.wikipedia.org/wiki/Capital_asset_pricing_model
To answer Question 1 related to the type of factors that influence company beta, read the following article:
l-Qaisi, K.M. (2011). The economic determinants of systematic risk in the Jordanian capital market. International Journal of Business and Social Science, 2(20), 85-95. Retrieved May 2012 from http://www.ijbssnet.com/journals/Vol_2_No_20_November_2011/9.pdf
Arbitrage Pricing Theory
Money Terms (2011). Arbitrage pricing theory. Retrieved May 2012 from http://moneyterms.co.uk/apt/
The following sources, though not recent, are useful to answer the Case Assignment questions:
Goetzmann, W. (1996). Chapter six: the arbitrage pricing theory. An introduction to investment theory. Yale School of Management [Online]. Retrieved May 2012 from http://viking.som.yale.edu/will/finman540/classnotes/class6.html
Boehme, R. (n.d.). Chapter 11: arbitrage pricing theory (APT). Retrieved May 2012 from http://www.rdboehme.com/MBA_CF/Chap_11.pdf
Otuteye, E. (1998). The arbitrage pricing dichotomy. Canadian Investment Review, 11(4), 60-64.
