Reference no: EM132543702
Question 1. Calculate the cost of equity using the Capital Asset Pricing Model (CAPM). The CFO estimates the Beta as 0.90. Management wants to use the 30 year bond rate as the risk free rate, arguing that Investors should make long term investments; that rate is 3% today. The expected return on the stock market as a whole has been estimated to be 7%, 10% and 12% by various studies. The CFO asks that you use an expected return of 9% for the average stock. The market risk Premium (RPM) will be 6%. 9% minus 3% = 6%.
Calculate the cost of equity (Rs) using the CAPM. The formula is Rs = rRF + (RPM ) x β. Rs is the required return on equity or the Cost of Equity, rRF is the risk free rate, RP M is the required stock market return in excess of the risk free rate, and β , (Beta) is the stocks relative risk. β is also described as the estimate of the amount of risk that an individual stock contributes to a well balance portfolio.
Question 2. The Discounted Cash Flow model is referred to as the Direct Dividend Model in the MBA 620 course materials. The formula reduces to Rs = (D1 / P0 ) + g where Rs is the required return on equity or the Cost of Equity, D1 is the expected future dividend, P0 is the price of the stock today and g is the expected growth in dividends. The CFO notes that the expected future dividend is $2.38 and the expected growth rate is 7%. For this calculation, please use the March 17, 2020 closing price of $138.70 per share. Calculate the cost of equity (Rs) using the DCF approach.
Question 3. Cristina Flores is an advisor to a board member who works at a private equity firm. She has told the CFO that sophisticated investors use a quick estimate of the cost of equity. She says that the cost of equity must logically be higher than the company's debt rate. The estimate is that 3% to 5% should be added to the company's long term interest rates. McCormick & Company estimates its current borrowing cost at 4%. Make your own estimate of the relative risk of McCormick & Company. Then, calculate the cost of equity (Rs) using this "own debt plus 3% to 5%" formula.
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