# COST OF EQUITY OF KMART

I need assistance with the following assignment:

In the previous part of the SLP you considered the market value of the company's long and short term debt and the market value of your company's equity.

In this section of the Session Long Project you'll estimate the cost of equity or the rate of return that your company's shareholders 'require'.

The CAPM (http://www.duke.edu/~charvey/Classes/ba350/riskman/riskman.htm) states the following equilibrium relationship between the (excess) rate of return that shareholders of a particular company "j" require (or actually in some sense 'deserve' if they fully diversify their investments) and the (excess) expected rate of return on the market portfolio.

In order to estimate the cost of equity for your company you need to obtain an estimate of the company's 'beta' or systematic risk coefficient, on the annual rate of return on a risk-free investment, and on the expected rate of return on the 'market portfolio'. You can easily find that information by going to the following web site: http://finance.yahoo.com and insert the name of your company. The beta of the company is reported on that web site.

1. Find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year. That rate is the 'risk-free rate'.

2. It is customary to assume that the difference between the expected rate of return on the 'market portfolio' and the risk-free rate return is about 7.0%. This is the expression [RM - RF] . So if for example the risk-free rate of interest is, say, 3% per year, than the expected rate of return on the 'market portfolio', RM, is 10%.

3. Apply the information you gathered in 1 through 3 to estimate the rate of return that the shareholders of your company require on their investment. This rate is called the cost of equity of your company.

For extra points - an optional question:

4. The systematic risk coefficient or the beta of the company is affected by the nature of the business, that is, by the extent to which the operating performance of the company is or is not closely related to the performance of the economy as a whole, and by the debt to equity ratio of the company, or the financial leverage. The relationship between the so-called 'equity beta' and the 'operating, or 'asset beta' of a company is expressed in the following equation:

A [1 + (1 - T) (D*/E*)] ,

E is the equity beta, or the beta that you actually obtained by browsing for information on your company, is the 'asset beta' or the systematic risk coefficient of the operating performance of the company, T is the tax rate (assume 34%) and D* and E* are the market value of debt and of equity of your company (information you reported on your Module 2 SLP).

You now have all the information to compute and to report on your company's 'asset beta'. The asset beta reflects the extent to which the company's business performance is related to the overall performance of the economy. Are you surprised by the 'asset beta' of your company? Explain.

The report should be two to three pages in length.

Thanks in advance for your time and assistance!!

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#### Solution Preview

THE COST OF EQUITY OF KMART

I need assistance with the following assignment:

In the previous part of the SLP you considered the market value of the company's long and short term debt and the market value of your company's equity.

In this section of the Session Long Project you'll estimate the cost of equity or the rate of return that your company's shareholders 'require'.

The CAPM (http://www.duke.edu/~charvey/Classes/ba350/riskman/riskman.htm) states the following equilibrium relationship between the (excess) rate of return that shareholders of a particular company "j" require (or actually in some sense 'deserve' if they fully diversify their investments) and the (excess) expected rate of return on the market portfolio:

Rj - RF = βj [RM - RF]

It follows that the rate of return that shareholders require or expect to earn on their investment in the shares of the company, or 'the cost of equity' is:

Rj = RF + ;j [RM - RF]

In order to estimate the cost of equity for your company you need to obtain an estimate of the company's 'beta' or systematic risk coefficient, on the annual rate of return on a risk-free investment, and on the expected rate of return on the 'market portfolio'. You can easily find that information by going to the following web site: http://finance.yahoo.com and insert the name of your company. The beta of the company is reported on that web site.

1. Find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year. That rate is the 'risk-free rate'.

2. It is customary to assume that the difference between the expected rate of return on the 'market portfolio' and the risk-free rate return is about 7.0%. This is the expression [RM - RF] . So if for example the ...

#### Solution Summary

This explains the steps to compute cost of equity by taking the example of Kmart