The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using the 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 the CAPM model:
E(rj)= RRF + βj (RM - RRF)
E(rj) - The cost of equity
RRF - Risk-free rate of return
ßj - Beta of the security
RM - Return on market portfolio
Based on the above information, which company has higher cost of equity? Why? Briefly explain your reasoning.
The CAPM model shows that risk-free rate of return, return on market portfolio, and company beta determine the cost of equity.
What type of factors influence company beta? Briefly describe the factors that influence company beta. For example, higher financial leverage (total liabilities to total assets ratio) can lead to higher company beta.
In this exercise you are using the Capital Asset Pricing Model (CAPM) to calculate the cost of equity of three publicly traded companies.
E(rj) = RRF + Beta of company (RM - RRF)
Where E(rj) = cost of equity, RRF = risk-free rate, RM = market return, and Beta = beta value of the company.
To find the cost of equity for each of the companies, you can derive the answers by plugging in the numbers into the formula. Thus,
E(NKE) = 0.40 + 0.90 (6.50 - 0.40) = 5.89%
E(SNE) = 0.40 + 1.60 (9.50 - 0.40) = 14.96%
E(MCD) = 0.40 + 0.40 (8.50 - 0.40) = 3.64%
Notes: (1) Use correct order of operations. ...
This solution shows the detailed calculation of the cost of equity for three publicly traded companies (Nike, Sony, and McDonald's), using the CAPM (Capital Asset Pricing Model). In addition, the solution explains the general meaning of the beta and several factors that influence on the company beta.