See attached file for format of the table.
The cost of equity capital and the CAPM
The cost of equity capital for a company is the rate of return on investment required by the company’s shareholders. The rate of return consists of both the dividends and capital gains (e.g., an increase in the share price). The rates of return are expected future returns, not historical returns. Therefore, the returns on equity can be expressed as the anticipated dividends on the shares every year in perpetuity. Thus, the cost of equity is the cost of capital which will equate the current market price of the share with the discounted value of all future dividends in perpetuity.
To complete Part I of Module 3 Case Assignment, please review the background material on the capital asset pricing model, the material on the dividend growth model, and arbitrage pricing theory and do some of your own research using internet search engines and the CyberLibrary as well. These models provide some insights and tools to estimate the rate of return that investors in our company â??requireâ? in the sense that if they don’t see the possibility that they will earn that rate of return they will sell the shares and that of course will lower the market price per share.
These models use a set of assumptions that are not necessarily tenable.
You are asked by your board of directors to write a report explaining the challenge of estimating or coming with a good ‘feel’ for the “cost of equity capital” or the rate of return that you feel your company investors require as the minimum rate of return that they expect of require your company to earn on their investment in the shares of the company. There are several asset pricing models used to estimate the cost of equity capital that you have read about for this module in the background materials. After reading through the background materials, write a 5 to 6 pages report for the board of directors Apple Inc. by responding to the following tasks:
Which of the three models (dividend growth, CAPM, or APT) is the best one for estimating the required rate of return (or discount rate) of your company? Based on your analysis and findings, what would you recommend to the board of directors of your SLP company?
In your paper, include discussion of the following issues:
1. Ease of use of these three models
2. Accuracy of each of these three models
3. How realistic the assumptions of each model are
For this paper you need to take a clear stand and pick one of these three models to defend to the Board of Directors. You cannot tell the Board of Directors that “I like all three models,” they want you to come to them with a decisive choice of just one model.
The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using 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 CAPM model:
E(rj ) – The cost of equity
RRF – Risk free rate of return)
Ã?j – Beta of the security
RM – Return on market portfolio)
Based on the above information, which company has higher cost of equity? Why? Please explain your reasoning in brief.
See attached file for format of formulas and graphs.
The Capital Asset Pricing Model (CAPM) best serves the function of determining the
cost of equity for Apple Inc. Using CAPM calculations, at $384.771 per share, Apple’s target
security price for December 2012 is $405.43, (Reuters, 2011). If this security price becomes
unrealistic within the year, then options to boost investor return through a dividend should be
explored. While less accurate than arbitrage pricing theory (APT) and dividend growth models,
CAPM’s ease of use, and the isolation of Beta assumptions into a single variable best fit the
current state of Apple’s enterprise.
APPLE INC- COST OF EQUITY
CAPM would calculate the current cost of equity at 5.96%:
RE= RF + Beta(RM – RF)
RE= 3.25% + 1.21(5%-3.25%)
CAPM VARIABLES AND ASSUMPTIONS
Expanding the above calculation from left to right, each variable introduces new
assumptions, and becomes progressively more contentious. RF comprises the risk-free rate. In
this case, the US Prime Rate is used (Wall Street Journal, 2011). While traditionally, RF would
use a ―zero coupon government bond matching the time horizon of the cash flow being
analyzed,‖ the time horizon for our consideration is flexible, (Damodaran, nd). Instead, the Prime
Rate captures current aggregate market conditions and while admittedly it is an ―index, not a
law,‖ it closely matches various government treasury bonds, considers current inflation risk, and
is a function of the Federal Open Market Committee’s target rate for federal funds (Wall Street
1 Current as of market close, 4:00pm EDT, 16 November 2011.
Next, and more contentious than RF, is Beta. Beta represents a ―statistical analysis of past
price movements of an individual stock (against) the market as a whole,‖ (Investopedia, nd). In
this calculation, 1.36 was used (Reuters, 2011). While Beta is purported to be a mathematical
truth, the assumptions underpinning the concept are extremely fluid. For example, four separate
sources were consulted for Apple’s Beta value-these returned four distinct values ranging from
1.21 to 1.36 (Google Finance, Fidelity, Reuters). The Reuters value was settled on based solely
on the reputation of the source. The variance between these Beta values could be due to how
each defined the ―market as a whole.‖ Just to scratch the surface, they could use: S&P 500 index,
Wilshire 5000 index, Dow Jones Total Market Index, or any other infinite number of attempts to
capture ―the market.‖ This, of course, also assumes that ―the market‖ is comprised solely of the
stock market- which further assumes that such stock market is limited to domestic securities of
similar risk-adjusted expectations as the target security. In any case, Beta is a powerful variable
used in CAPM, with results highly dependent on its selection. In selecting from the limited pool
consulted, RE could vary between 5.63% and the settled upon 5.37%.
Lastly for CAPM, and clearly the most …
Uses a case study on Apple, Inc to illustrate the effectiveness of the Capital Asset Pricing Model (CAPM) as compared to the Arbitrage Pricing Theory (APT), and Dividend Growth Models (specifically, the Gordon Growth Model).
9 pages. APA format including references.
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