In this section, you'll estimate the cost of equity or the rate of return that your company's (Target's) shareholders require. This is an important piece of information that every top manager must be able to estimate because it will be an important input in any effort to determine whether any particular course of action by the company will or will not add value to the shareholders.
We are going to use the Capital Asset Pricing Model (CAPM) in order to estimate the rate of return that our shareholders require on their investment. This is the minimum rate of return that these shareholders require. As stated above - we call this rate 'the cost of equity' and it is expressed in percentages or in a decimal format.
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 = Bj [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 (Target), or 'the cost of equity' is:
Rj = RF + Bj [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 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'.
Next, tt is customary to assume that the difference between the expected rate of return on the 'market portfolio' and the risk-free rate rate of 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%. So, multiply the 'beta' of your SLP Company by 7.0%. That will be the equivalent of your company's βj [RM - RF] . Then add to that number the current yield to maturity on a US Government bond [see step (1) above].
The above procedure provides you with an estimate of the rate of return that the shareholders of your SLP Company require on their investment. This rate is called the cost of equity of your company.
1. Show your work to used to obtain the cost of equity for your SLP company.
2. Is this cost of equity higher or lower than you expected?
3. Look up the betas for some of the other companies that you can compare your SLP company to. Using these betas, compute the cost of equity for these firms. How do they compare to your SLP company? Are you surprised that some firms have a higher or lower cost of equity than your SLP company?
4. How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for your SLP company? Don't worry, you don't actually have to do any calculations - just explain how you would go about doing these calculations and explain what kind of additional information you might need.