FIN501 - Strategic Corporate Finance Module 3 - Case - 9995

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The cost of equity capital and the CAPM

 

 

 

Part I

 

 

 

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 “require” 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 (of your SLP Company) 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. 

 

 

 

Part II

 

 

 

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:

 

 

 

Company

Listing

RRF

RM

ßj

Nike Inc.

NYSE: NKE

1%

4.49%

0.91

Sony Corporation

NYSE: SNE

1%

6.83%

1.48

McDonald’s Corporation

NYSE: MCD

1%

2.94%

0.36

 

 

 

E(rj )= RRF + b(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? Please explain your reasoning in brief.

 

 

 

What do you perceive you have learnt in Module 3 Case Assignment? Please provide your evaluation of the Module 3 Case Assignment in brief.

 

 

 

NOTE: Please note that your report/assignment will not be accepted without proper citations and references. You must use the sources from the background material together with the sources you find your own.   

 

 

 

Case Assignment Expectations:

 

 

 

In Module 3 Case Assignment, you are expected to:

 

 

 

?Describe the purpose of the paper and conclusion.

 

 

 

?Answer the case assignment questions clearly and provide necessary details and calculations. Your very first paragraph should include a direct answer to the assignment question, with the body of your paper focused on defending your answer. See the attached Tips for Good Writing for more detail on these expectations.

 

 

 

?Provide a quality argument; that is, no poor sentence structure, no spelling and grammar mistakes or run-on sentences.

 

 

 

?Provide citations to support your argument and references on a separate page. Please use APA format to provide citations and references [http://owl.english.purdue.edu/owl/resource/560/01/ ; http://www.tuiu.edu/guidelines/Well-Written-Paper.pdf].  

 

 

 

?Answer all the case assignment questions in an essay format instead of point format. Please do not type questions in the paper.

 

 

 

?Type and double space the paper.

 

 

 

? The following criteria will also be used to assess your paper:

 

 

 

>Precision: Does the paper address the question(s) or task(s)?

 

 

 

>Breadth: Is the full breadth of the subject, i.e., all the keys to the assignment, addressed?

 

 

 

>Depth: Does the paper/report address all elements of the topic in sufficient depth? Does it include and apply the background readings and other background resources? Are they included as references?

 

 

 

>Critical thinking: Are the concepts of this module applied accurately, logically, and relevantly?

 

 

 

>Organization: Is the paper organized in a coherent and systematic manner? Are headings included in all papers greater than 2 pages?

 

 

 

>Clarity: Is the writing clear and the concepts articulated properly? Are paraphrasing and synthesis of concepts the primary means of response to the questions, or are thoughts conveyed through excessive use of quotations?

 

 

 

In the grading of your assignment, you will be assessed on the following items:

 

 

 

1. The use of multiple references including both references in the background materials as well as references you find from your own research in the TUI CyberLibrary or internet search engines.

 

 

 

2. Your paper from beginning to end on the precise assignment question. No need for lengthy background information. Your very first paragraph should include a direct answer to the assignment question, with the body of your paper focused on defending your answer.  See the attached Tips for Good Writing for more detail on these expectations.

 

 

 

3. Your paper should be at least five pages in lengths and must provide necessary calculations.

 

 

 

Solution Description

 

The cost of equity capital and the CAPM

 

 

 

Part I

 

 

 

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 “require” 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.

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