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Risk and return, portfolio diversification and the Capital Asset Pricing Model; The cost of equity

The Cost of Equity

In this section you’ll estimate the cost of equity or the rate of return that your company’s shareholders require. This is an important piece of information that every top manager must be able to estimate because it will be an important input in any effort to determine whether any particular course of action by the company will or will not add value to the shareholders.

We are going to use the Capital Asset Pricing Model (CAPM) in order 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 = ?j [RM – RF]

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 + ?j [RM – RF]

In order to estimate the cost of equity for your company, you need to 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 insert the name of BestBuy. The beta of the company is reported on that web site.

Click on the “key statistics” link on the left hand side of the screen to find the beta and other information.

First out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year. 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 7.0%. This is the expression [RM – RF]. So, if for example, the risk-free rate of interest is, say, 3% per year, than the expected rate of return on the �market portfolio,� RM, is 10%. So, multiply the �beta� of your Company by 7.0%. That will be the equivalent of your company’s ?j [RM – RF]. Then add to that number the current yield to maturity on a US Government bond [see step (1) above]. 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 = 3, RM =10 and [RM – RF]= 7.

The above procedure provides you with an estimate of the rate of return that the shareholders of BestBuy require on their investment. This rate is called the cost of equity of BestBuy.

After going through these calculations, write a two to three page paper with the following information:

1) Show your work that you used to obtain the cost of equity for BestBuy.

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 10.2 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 some of the other companies that you compared BestBuy to. These are the companies that you had to explain had a higher or lower discount rate than BestBuy. Using these betas, compute the cost of equity for these firms. How do they compare to your company? Are you surprised that some firms have a higher or lower cost of equity than your company?

4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for BestBuy? Don’t worry, you don’t actually 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 learnt in this project? Which of the following learning objectives 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

?Derive, examine and explain the relationship between the systematic risk coefficient on the company’s operations (‘asset beta’), the systematic risk to its shareholders (‘equity beta’) and the relationship of both concepts to the debt/equity ratio of the company

?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 in order to estimate the implicit cost of equity of a mature, stable company

Please provide your evaluation of the project in brief.

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