Current Yield to Maturity (YTM) on a U.S. Government bond that matures based on the Treasury Bill Rate for 1 year is 0.10 and for 13 weeks is 0.02.
For Amazon.com the following is assumed:
RF = 1
RM - RF= 4
What is the cost of equity for Amazon.com?
Based on the Betas of Ebay and Overstock.com compute their cost of equity. How does each compare to Amazon.com. Is it surprising that Ebay and Overstock have a higher or lower cost of equity?
Do you think your Amazon.com should have a lower or a higher cost of capital than the average organization which is 8.2%?
Explain how would you go about finding the cost of equity using the APT model and the dividend growth model for Amazon? What additional information might be needed that is not needed in using CAPM?
Computation for Amazon's Cost of Equity using CAPM
Cost of equity for Amazon = risk free rate + beta*Risk premium = RF + Beta*(RM-RF) = 0.10% + 0.77*(5%-0.10%) = 3.94%
The above cost of equity computation used the capital asset pricing model.
Please double check your initial computation of risk premium. Risk free rate is not 1%, but 0.10%.
Computation for eBay's Cost of Equity using CAPM
Beta = 0.88 (Yahoo! Finance)
Cost of equity = 0.10% + 0.88*(5%-0.10%) = 4.49%
Computation for Overstock.com's Cost of Equity using CAPM
Beta = 0.38 (Yahoo! Finance)
Cost of equity = 0.10% + 0.38*(5%-0.10%) = 2.00%
I was really surprised that Overstock.com has a lower cost of equity than Amazon. This lower cost of equity means that the market views Amazon as a riskier business than Overstock.com which I strongly disagree. Amazon's business is now more stable than before and its business model has proven to be sound.
As for eBay's cost of equity, I expected that it will be higher than Amazon given eBay's business. Amazon owns portion of its goods for sale giving it more control ...
This solution involves calculating the cost of equity using a capital asset pricing model.
Capital Asset Pricing Model Assistance
Explain how the CAPM assists in measuring both risk and return.
Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.
Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.
Identify the benefits and drawbacks of using the CAPM.