We are going to use the Capital Asset Pricing Model(CAPM)in order to estimate the rate of return...

Question

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.

TheCAPMstates 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:

R_j

- R_F

= ß_j

[R_M

- R_F]

E(r_j)
- The cost of equity

R_RF

- Risk free rate of return

ß_j

- Beta of the security

R_M

- 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:

R_j

= R_F

+ ß_j

[R_M

- R_F]

In order to estimate the cost of equity for Google, 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.comand 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.”

Next, it is customary to assume that the difference between the expected rate of return on the “market portfolio” and the risk-free rate of return is about 5.0%. This is the expression [R_M- R_F]. So, if for example, the risk-free rate of interest is, say, 1% per year, then the expected rate of return on the “market portfolio,” RM, is 6%. So, multiply the “beta” of your SLP Company by 5.0%. That will be the equivalent of your company's ß_j[R_M- R_F]. Then add to that number the current yield to maturity on a US Government bond [see step (1) above].You are free to try to research and find more up to date values ofR_Mand R_F, butto simplify this assignment you can also assume that R_F= 1, R_M=5 and[R_M- R_F]= 4.

The above procedure provides you with an estimate of the rate of return that the shareholders of Google Inc. require on their investment. This rate is called thecost of equityof Google Inc.

After going through these calculations, write a two to three page paper with the following information:

1) Show your work that you used to obtain the cost of equity for Google.

2) 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 thinkyour firm should have a lower or a higher cost of capital than the average firm?

3)Look up the betas on Yahoo and Amazon to compare to Google.

These are the two companies that you had to explain had a higher or lower discount rate than Google. Using these betas, compute the cost of equity for these firms.How do they compare to Google?Are you surprised that the two other firms have a higher or lower cost of equity than Google? You can find company beta by using the websitehttp://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.

4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for Google?

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.

Please list a reference page at the bottom and please cite references throughout the paper.

005_x5j485k-ky0qts01.doc

David · Accepted Answer

Capital Asset Pricing Model 
Capital Asset Pricing Model estimates the cost of equity on the basis of risk free rate and 
expected return. It calculates the expected return on an investment which helps in the comparison 
of expected return with the required rate of return so as determine whether the asset is 
underpriced, overpriced or properly priced. The basic idea behind the capital asset pricing model 
is that investors should get a reward for both waiting and worrying. The greater the worry, the 
greater the expected return. If investment is made in a risk-free Treasury bill, then only the risk 
free rate of interest will be received. When you invest in risky stocks, you can expect an extra 
return over the risk free rate or risk premium for worrying, which is called as reward for 
worrying. 
Ke = Rf + Beta * (Rm – Rf) 
Where, 
Ke = Cost of Equity 
Rf = Risk free rate 
Rm = Market Rate of Return 
Beta = Measure of risk 
 About the company 
Google Inc. is the multinational corporation of America engaged in the business of internet 
related products and services. It was founded by Larry Page and Sergey Brin. It was incorporated 
as privately held company in September 4, 1998. Google is focusing on the three main 
businesses i.e. the search, advertisement and the application based business. The core technology 
business is search, the central business is ads and the apps act like an umbrella of the software 
which is web based and is easily accessible from anywhere, at any time.

Sun	Mon	Tue	Wed	Thu	Fri	Sat
30	31	1	2	3	4	5
6	7	8	9	10	11	12
13	14	15	16	17	18	19
20	21	22	23	24	25	26
27	28	29	30	1	2	3

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...

Answer To: We are going to use the Capital Asset Pricing Model (CAPM) in order to estimate the rate of return...

Answer To This Question Is Available To Download

Related Questions & Answers

Submit New Assignment