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This post calculates the cost of equity for XYZ Corp.

You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns:

2007 Risk free return 3% Market return 6% XYZ return 10%
2008 Risk free return 1% Market return -37% XYZ return -45%

A) What was XYZ's average historical return?

B) Compute the markets and XYZ's excess returns for each year. Estimate XYZ's beta.

C) Estimate XYZ's historical alpha.

D) Suppose the current risk-free rate is 3%, and you expect the markets return to be 8%. Use the CAPM to estimate the expected return for XYZ Corps stock.

E) Would you base your estimate of XYZ's equity cost of capital on your answer in part (a) or in part (d)? How does your answer to part (c) affect your estimate? Explain.

Solution Preview

A) What was XYZ's average historical return?

10% - 45% / 2 - -17.5%
answer: -17.5%

B) Compute the markets and XYZs excess returns for each year. Estimate XYZs beta.

Excess returns:
MKT 3%, -38%
XYZ 7%, ...

Solution Summary

The solution provides a detailed explanation of each part of the exercise. All calculations are given for the exercise and all parts are answered. The main question states, You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns:

2007 Risk free return 3% Market return 6% XYZ return 10%
2008 Risk free return 1% Market return -37% XYZ return -45%

Calculations are shown for all answers.

$2.19