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    Strategic Corporate Finance

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    I need some help with this. Can you please show all work so that I may understand the concept?

    The CAPM 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 = beta [RM - RF]
    E(rj) - The cost of equity
    RRF - Risk free rate of return
    Beta - Beta of the security
    RM - Return on market portfolio
    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 + beta [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.
    Click on the "key statistics" link on the left hand side of the screen to find the beta and other information.
    First find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year or 13 weeks Treasury Bill Rate [http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield]. That rate is the "risk-free rate."

    - What is the cost of equity for Lowes Company.
    - 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 8.2 percent. Would you think your firm should have a lower or a higher cost of capital than the average firm?
    - Look up the betas for Home Depot and Orchard Supply Hardware Stores Corp. Using these betas, compute the cost of equity for these firms. How do they compare to Lowes? Are you surprised that some firms have a higher or lower cost of equity than Lowes?
    You can find company beta by using the website http://ca.finance.yahoo.com/. For example, you want to find beta of General Electric Company. You will need to key in company code "GE" and then click on "Key Statistics" (http://ca.finance.yahoo.com/q/ks?s=GE). You will be able to find beta of the company.
    - How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for Lowes? Just explain how you would go about doing these calculations and explain what kind of additional information you might need.

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    Solution Preview

    The problem has given us the formula for expected rate of return on investment:
    Rj = Rf + beta (Rm - Rf), where Rj is the return shareholders require, Rf is the risk free rate of return, beta is the beta of the security, and Rm is the Return on market portfolio.

    For Lowe's Company:
    Now, on 11/9 the cost of equity on 11/09/12, 1 year yield to maturity is 0.18%. This is the risk free rate. The US high quality expected market return rate is 4.8% a year. This is the return on market portfolio.
    The beta of Lowes Company from Yahoo Finance is: 1.19.
    The return shareholders require from Lowe is: 0.18 + 1.19 (4.8 - 0.18) = 5.68. This is the cost of equity.
    The cost of equity is lower than what I expected. Lowes cost is 5.68, which is less than the cost of capital of the average S&P 500 firm. The cost of equity is lower than what I had expected because the net income of Lowes has declined from 2.0 billion in 2011 to 1.83 billion in ...

    Solution Summary

    Corporate Finance is explained in a structured manner in this response. The answer includes references used.