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CAPM Cost of Equity

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Please check CAPM calculations for Nike, Sony and McDonalds.

CAPM would calculate Nike's current cost of equity at 2.859%
RE = RF + Beta(RM - RF)
RE = 20% + 0.91(7.50% - 20%)
RE = 2.859%

This calculation is based on a variable market rate of return and a risk free rate. Using a variable market rate of return may be appropriate in comparing companies assuming the market rate is risk-adjusted.

CAPM would calculate Sony's current cost of equity at 2.148%
RE = RF + Beta(RM - RF)
RE = 20% + 1.48(8.50% - 20%)
RE = 2.148%

CAPM would calculate McDonald Corporation current cost of equity at 2.036%
RE = RF + Beta(RM - RF)
RE = 20% + 0.36(9.50% - 20%)
RE = 2.036%

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Solution Preview

Dear Student:

You are using the Capital Asset Pricing Model to calculate the cost of equity of the three companies.

RE = RF + Beta(RM - RF)

Where RE = cost of equity, RF = risk-free rate, RM = market return, and beta = beta value of the company. You are using the correct formula. However, your answers are not correct.

By solving RE using your numbers for Nike RE = 20% + 0.91(7.50% - 20%) = 20% + 0.91(-12.5%) = 20% + (-11.375%) = + 8.625%

Note that my answer is not the same as yours. I could not figure out how you got that answer, but I assume it is either by using the incorrect order of operations or using beta as a ...

Solution Summary

This solution shows the calculation of the cost of equity for three companies (Nike, Sony, McDonald's), using Capital Asset Pricing Model (CAPM). The solution also illustrates how to find the values of beta, risk-free rate, and market return using Internet sources.

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See Also This Related BrainMass Solution

The cost of equity capital and the CAPM for Time Warner

Review the capital asset pricing model and the dividend growth model. Both models provide some insights and tools to estimate the rate of return that investors in Time Warner 'require' in the sense that if they don't see the possibility that they'll earn that rate of return they'll sell the shares and that of course will lower the market price per share.

Both models use a set of assumptions that are not necessarily tenable.

You are asked by the board of directors of Time Warner to write a report explaining the challenge of estimating or coming with a good 'feel' 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 expect of require your company to earn on their investment in the shares of the company. Note that the investment is not the amount shareholders spent buying the share of the company in the past. The true investment is in terms of today's share prices because shareholders COULD have sold their shares today, and if they decided to hang on to these shares instead of selling these shares off this is their true investment in the shares of the company as of today. (This is the correct concept of the opportunity cost to the investors or the shareholders.)

Write a report to the board of directors of TIME WARNER regarding the following issues:

(1) In estimating the rate of return required by the shareholders on their investments in the company's equity one approach is to use the dividend growth model. Explain the assumptions that are necessary for using the dividend growth model, tell the board members how you would estimate the cost of equity or the required rate of return by the shareholders of the company using that model. Then briefly state and defend your position as to whether the model is appropriate for your SLP Company's use.

(2) An alternative, more sophisticated approach is to use the CAPM. Explain and state the assumptions used in the CAPM and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM.

(3) Finally give the board members some explanations as to how the CAPM is related to the so-called 'modern portfolio theory'. (Some members of the board heard of the model and are interested in your explanation to this issue)

And here's a challenge: suppose you try to estimate the cost of equity of a company that is not traded on any stock exchange. How would you go about estimating its cost of equity or the required rate of return by the shareholders of that company. [Hint: Read question (4) - the 'optional question' of the Session Long Project of this Module before you answer this question.]

[Note: You'll be applying these concepts and actually estimate the cost of equity or the rate of return that the shareholders of 'your SLP Company' require in the Session Long Project of this Module.]

Be sure to include an appropriate reference list.

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