Part I
The cost of equity capital for a company is the rate of return on investment required by the company's shareholders. The rate of return consists of both the dividends and capital gains (e.g., an increase in the share price). The rates of return are expected future returns, not historical returns. Therefore, the returns on equity can be expressed as the anticipated dividends on the shares every year in perpetuity (stream of cash payments that never ends). Thus, the cost of equity is the cost of capital that will equate the current market price of the share with the discounted value of all future dividends in perpetuity.
To complete Part I of the Module 3 Case Assignment, review the background material on the capital asset pricing model, the material on the dividend growth model, and arbitrage pricing theory and do some of your own research using Internet search engines and the CyberLibrary. These models provide some insights and tools to estimate the rate of return that investors in our company â€œrequireâ€ in the sense that if they don't see the possibility that they will earn that rate of return, they will sell the shares, and that of course will lower the market price per share.
These models use a set of assumptions that are not necessarily tenable.
You are asked by your board of directors to write a report explaining the challenge of estimating or coming up with a good â€œfeelâ€ for the "cost of equity capital" or the rate of return that you feel your company investors require as the minimum rate of return that they expect or require your company to earn on their investment in the shares of the company. There are several asset pricing models used to estimate the cost of equity capital that you have read about for this module in the background materials. After reading through the background materials, write a 5- to 6-page report for the board of directors (of your SLP company) by responding to the following questions:
Which of the three models (dividend growth, CAPM, or APT) is the best one for estimating the required rate of return (or discount rate) of your company? Based on your analysis and findings, what would you recommend to the board of directors of your SLP company?
In your paper, include discussion of the following issues:
For this paper you need to decisively choose one of these three models to defend to the board of directors.
Part II
The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using the CAPM model is often more difficult than using the dividend discount model. The companiesâ€™ financial statements do not show the cost of equity.
The following table shows necessary (hypothetical) information to calculate the cost of equity by using the CAPM model:
Company |
Listing |
R_{RF} |
R_{M} |
ÃŸ_{j} |
Nike Inc. |
NYSE: NKE |
0.40% |
6.50% |
0.90 |
Sony Corporation |
NYSE: SNE |
0.40% |
9.50% |
1.60 |
McDonaldâ€™s Corporation |
NYSE: MCD |
0.40% |
8.50% |
0.40 |
E(r_{j})= R_{RF} + Î²_{j} (R_{M} - R_{RF})
E(r_{j}) - The cost of equity
R_{RF} - Risk-free rate of return
ÃŸ_{j} - Beta of the security
R_{M} - Return on market portfolio
The CAPM model shows that risk-free rate of return, return on market portfolio, and company beta determine the cost of equity.
What type of factors influence company beta? Briefly describe the factors that influence company beta. For example, higher financial leverage (total liabilities to total assets ratio) can lead to higher company beta.
NOTE: Your report/assignment will not be accepted without 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.
In the Assignment, you are expected to:
Subject | Business |
Due By (Pacific Time) | 09/09/2014 12:00 am |
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