# Cost of Equity- Apple

See attached file for format of the table.

The cost of equity capital and the CAPM

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. Thus, the cost of equity is the cost of capital which will equate the current market price of the share with the discounted value of all future dividends in perpetuity.

To complete Part I of Module 3 Case Assignment, please 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 as well. These models provide some insights and tools to estimate the rate of return that investors in our company â??requireâ? 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 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 they expect of 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 pages report for the board of directors Apple Inc. by responding to the following tasks:

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:

1. Ease of use of these three models

2. Accuracy of each of these three models

3. How realistic the assumptions of each model are

For this paper you need to take a clear stand and pick one of these three models to defend to the Board of Directors. You cannot tell the Board of Directors that "I like all three models," they want you to come to them with a decisive choice of just one model.

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 CAPM model is often more difficult than using the dividend discount model. The companies' financial statements do not show the cost of equity.

The following table shows necessary (hypothetical) information to calculate the cost of equity by using CAPM model:

Company

Listing

RRF

RM

Ã?j

Nike Inc.

NYSE: NKE

1%

4.49%

0.91

Sony Corporation

NYSE: SNE

1%

6.83%

1.48

McDonald's Corporation

NYSE: MCD

1%

2.94%

0.36

E(rj ) - The cost of equity

RRF - Risk free rate of return)

Ã?j - Beta of the security

RM - Return on market portfolio)

Based on the above information, which company has higher cost of equity? Why? Please explain your reasoning in brief.

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#### Solution Preview

See attached file for format of formulas and graphs.

INTRODUCTION

The Capital Asset Pricing Model (CAPM) best serves the function of determining the

cost of equity for Apple Inc. Using CAPM calculations, at $384.771 per share, Apple's target

security price for December 2012 is $405.43, (Reuters, 2011). If this security price becomes

unrealistic within the year, then options to boost investor return through a dividend should be

explored. While less accurate than arbitrage pricing theory (APT) and dividend growth models,

CAPM's ease of use, and the isolation of Beta assumptions into a single variable best fit the

current state of Apple's enterprise.

APPLE INC- COST OF EQUITY

CAPM would calculate the current cost of equity at 5.96%:

RE= RF + Beta(RM - RF)

RE= 3.25% + 1.21(5%-3.25%)

RE= 5.37%

CAPM VARIABLES AND ASSUMPTIONS

Expanding the above calculation from left to right, each variable introduces new

assumptions, and becomes progressively more contentious. RF comprises the risk-free rate. In

this case, the US Prime Rate is used (Wall Street Journal, 2011). While traditionally, RF would

use a ―zero coupon government bond matching the time horizon of the cash flow being

analyzed,‖ the time horizon for our consideration is flexible, (Damodaran, nd). Instead, the Prime

Rate captures current aggregate market conditions and while admittedly it is an ―index, not a

law,‖ it closely matches various government treasury bonds, considers current inflation risk, and

is a function of the Federal Open Market Committee's target rate for federal funds (Wall Street

Journal, 2011).

1 Current as of market close, 4:00pm EDT, 16 November 2011.

Next, and more contentious than RF, is Beta. Beta represents a ―statistical analysis of past

price movements of an individual stock (against) the market as a whole,‖ (Investopedia, nd). In

this calculation, 1.36 was used (Reuters, 2011). While Beta is purported to be a mathematical

truth, the assumptions underpinning the concept are extremely fluid. For example, four separate

sources were consulted for Apple's Beta value-these returned four distinct values ranging from

1.21 to 1.36 (Google Finance, Fidelity, Reuters). The Reuters value was settled on based solely

on the reputation of the source. The variance between these Beta values could be due to how

each defined the ―market as a whole.‖ Just to scratch the surface, they could use: S&P 500 index,

Wilshire 5000 index, Dow Jones Total Market Index, or any other infinite number of attempts to

capture ―the market.‖ This, of course, also assumes that ―the market‖ is comprised solely of the

stock market- which further assumes that such stock market is limited to domestic securities of

similar risk-adjusted expectations as the target security. In any case, Beta is a powerful variable

used in CAPM, with results highly dependent on its selection. In selecting from the limited pool

consulted, RE could vary between 5.63% and the settled upon 5.37%.

Lastly for CAPM, and clearly the most ...

#### Solution Summary

Uses a case study on Apple, Inc to illustrate the effectiveness of the Capital Asset Pricing Model (CAPM) as compared to the Arbitrage Pricing Theory (APT), and Dividend Growth Models (specifically, the Gordon Growth Model).

9 pages. APA format including references.

Apple: Cost of Equity

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.

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.

Estimate the cost of equity for Apple Inc.

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

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 Apple Inc.

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 Hewlett Packard and Microsoft that you compared Apple Inc to for your Module 2 SLP. These are the companies that you had to explain had a higher or lower discount rate than Apple Inc. Using these betas, compute the cost of equity for these firms. How do they compare to Apple Inc? Are you surprised that some firms have a higher or lower cost of equity than Apple Inc?

4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for Apple Inc? 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.

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