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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.

Solution Preview

Please see attached file.

(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, how you would estimate the cost of equity or the required rate of return by the shareholders of a company using that model, and then briefly state and defend your position as to whether the model is appropriate for your SLP Company's use.

A firm's long-term success depends upon the firm's investments earning a sufficient rate of return. This sufficient or minimum rate of return necessary for a firm to succeed is called the cost of capital.

The cost of capital can also be viewed as the minimum rate of return required keeping investors satisfied. Thus it is used to know the rate of return expected by the investors. Thus cost of capital is used to evaluate the project. It is also known as discount rate.

The present value of stock can also be found using the Discounted Dividend Model. The Dividend Discount Model uses the present value of the stock, the expected future dividends, and the growth rate. This model is similar to the Constant Growth Model accept it discounts the dividends at the expected return instead of discounting the free cash flows at the weighted average cost of capital.

VS = Stock Value
D0 = Dividend at time 0 (most recent)
g = Growth rate
rS = Stockholders Required Rate of Return

Note:

The dividend-growth approach has limited application in practice
? It assumes that the dividend per share will grow at a constant rate, g, forever.
? The expected dividend growth rate, g, should be less than the cost of equity, key, to arrive at the simple growth formula.
? The dividend-growth approach also fails to deal with risk directly.

(2) An alternative, more sophisticated ...

Solution Summary

This provides the steps to compute cost of equity capital and the CAPM for Time Warner

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