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Company: GE-General Electric
Risk and return, portfolio diversification, and the Capital Asset Pricing Model;
The cost of equity
The cost of equity
Background
The Cost of Equity
In this section of the Session Long Project you will estimate the cost of equity or the rate of return that your company's shareholders “require.” This is a vital piece of information: Every top manager must be able to estimate this because it will be an important input in determining whether any particular course of action will or will not add value for the shareholders.
Session Long Project
We are going to use the Capital Asset Pricing Model (CAPM) 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 = βj [RM - RF]
E(rj) - The cost of equity
RF - Risk-free rate of return
ßj - Beta of the security
RM - 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:
Rj = RF + βj [RM - RF]
Assignment Expectations
To estimate the cost of equity for your company, 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 inserting the name of your company. The beta of the company is reported on that website.
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 U.S. 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 [RM - RF]. For example, if the risk-free rate of interest is 1% per year, the expected rate of return on the “market portfolio,” RM, is 6%. Multiply the “beta” of your SLP company by 5.0%. That will be the equivalent of your company's βj [RM - RF]. Add to that number the current yield to maturity on a U.S. Government bond (see previous paragraph). You are free to try to research and find more up-to-date values of RM and RF, but to simplify this assignment you can also assume that RF = 1, RM =5 and [RM - RF]= 4.
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.
After going through these calculations, write a 2- to 3-page paper with the following information:
Show the work you did to obtain the cost of equity for your SLP company.
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 think your firm should have a lower or a higher cost of capital than the average firm?
Look up the betas for some of the other companies that you compared your SLP company to for your Module 2 SLP.These are the companies that you had to explain had a higher or lower discount rate than your SLP company. 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?
You can find company beta by using the website http://ca.finance.yahoo.com/. For example, you want to find beta of General Electric Company. 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.
How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for your SLP company? You do not 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.
Note: 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 on your own. It is also required that you answer all the questions related to learning outcomes.
Assignment Expectations:
In the Module 3 SLP, you are expected to:
Describe the purpose of the paper and provide a conclusion. An introduction and a conclusion are important because many busy individuals in the business environment may only read the first and the last paragraph. If those paragraphs are not interesting, they never read the body of the paper.
Answer the SLP questions clearly and provide necessary details.
Write clearly and correctly—that is, no poor sentence structure, no spelling and grammar mistakes, and no run-on sentences.
Provide citations to support your argument and references on a separate page. Use APA format to provide citations and references [http://owl.english.purdue.edu/owl/resource/560/01/].
Answer all the SLP questions in an essay format. Do not type questions in the paper.
Type and double-space the paper.
Whenever appropriate, please use Excel to show supporting computations in an appendix, present financial information in tables, and use the data computed to answer follow-up questions. In finance, in addition to being able to write well, it’s important to present information in a professional manner and to analyze financial information. This is part of the assignment expectations and will be considered for grading purposes
