Cost Of Capital Essay

1828 words - 8 pages


the capital asset pricing model
relevant to ACCA Qualification Paper F9

the cost of equity
Section F of the Study Guide for Paper F9 contains several references to the Capital Asset Pricing Model (CAPM). This article introduces the CAPM and its components, shows how it can be used to estimate the cost of equity, and introduces the asset beta formula. Two further articles will look at applying the CAPM in calculating a project-specific discount rate, and will review the theory, and the advantages and disadvantages of the CAPM. Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the ...view middle of the document...

The sum of systematic risk and unsystematic risk is called total risk1. THE CAPITAL ASSET PRICING MODEL The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk. The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk at all of the return on the investment being different from the expected return. This minimum level of return is called the ‘risk-free rate of return’. The formula for the CAPM, which is included in the Paper F9 formulae sheet, is as follows: E(ri) = Rf + βi(E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium – βi(E(rm) Rf) – which compensates the investor for the systematic risk of the financial asset. If shares are being considered, E(rm) is the required return of equity investors, usually referred to as the ‘cost of equity’. The formula is that of a straight line, y = a + bx, with βi as the independent variable, Rf as the intercept with the y axis, (E(rm) - Rf) as the slope of the line, and E(ri) as the values being plotted on the straight line. The line itself is called the security market line (SML), as shown in Figure 1. FIGURE 1: THE SECURITY MARKET LINE Return E(ri) Rm Rf SML



In order to use the CAPM, investors need to have values for the variables contained in the model. THE RISK-FREE RATE OF RETURN In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset. In order to have consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free rate of return when applying the CAPM to shares that are traded on the UK capital market. Note that it is the yield on treasury bills which is used here, rather than the interest rate. The yield on treasury bills (sometimes called the yield to maturity) is the cost of debt of the treasury bills. January 2008 student accountant 69

Because the CAPM is applied within a given financial system, the risk-free rate of return (the yield on short-term government debt) will change depending on which country’s capital market is being considered. The risk-free rate of return is also not fixed, but will change with changing economic circumstances. THE EQUITY RISK PREMIUM Rather than finding the average return on the capital market, E(rm), research has concentrated on finding an appropriate value for (E(rm) - Rf), which...

Other Essays Like Cost of Capital

Weighted Average Cost of Capital Essay

762 words - 4 pages Solutions Guide:   This is meant as a solutions guide. Please try reworking the questions and reword the answers (especially essay type parts) so as to guarantee that your answer is an original. Do not submit as your own. Coogly Company is attempting to identify its weighted average cost of capital for the coming year and has hired you to answer some questions they have about the process. They have asked you to present this information in a

Nike Inc. - Cost of Capital

1391 words - 6 pages What is he WACC and why is it so important to estimate a firms cost of capital? The WACC (weighted average cost of capital) is a percentage figure resulting from a calculation method by which the adequate cost of capital of a firm is expressed. It considers the composition of a company’s funding, be it debt or equity. A corporation whose source of funding is equity by 100 percent will have a WACC equal to the cost of equity. By contrast, a

Lecture 16 - Cost of Capital (I)

1821 words - 8 pages Today Cost of Capital (Chapter 14) BAFI 355 – Spring 2010 16-1 Objective Today The cost of capital Know how to determine a firm s cost of equity capital firm’s Know how to determine a firm’s cost of debt Know how to determine a firm’s overall cost of capital But first, a bit more on CAPM… BAFI 355 – Spring 2010 16-2 The Security Market Line SML Line, Required rate of return, E(Ri) SML: E(Ri)=RF+βi[E(RM)-Rf

Marriott Corporation: The Cost Of Capital

1382 words - 6 pages Divisional hurdle rates at Marriott have a significant impact on the firm's financial and operating strategies. Marriott measures the opportunity cost of capital for investments of similar risk using the Weighted Average Cost of Capital ("WACC"). The scope of this analysis is to assist Marriott in selecting the appropriate hurdle rate for each division as of April 1988 ("Valuation Date"). As the risk entailed in each division is different

Nike: Cost of Capital Case Study

1820 words - 8 pages decrease in market sales and prices of stocks, management presented its plans to improve and perform better. Generally, the case issue is to examine if the share price of Nike is undervalue or overvalue for guide investors to buy or not and the common stock of Nike Inc should be added to the North Point Group’s Mutual Fund Portfolio or not. What is WACC? And why is it important to estimate a firm’s cost of capital? The weighted

Heinz: Estimating the Cost of Capital

2356 words - 10 pages H.J. Heinz Company Case: Cost of Capital in Times of Uncertainty Group 10 Alan Ho 20349978 Saraniya Paramanathan 20332829 Christopher Abeleda 20335744 Nathanael Cheung 20345672 Reuban Nadesan 20346511 To: Board of Directors Committee, H.J. Heinz Company From: Group 10 Consulting Date: July 7, 2011 ------------------------------------------------- Subject: Weighted Average Cost of Capital Recommendation

Financial Ratios, Growth Analysis, Cost of Capital, Capital Structure, & Capital Budgeting Analysis for Starbucks Corp

1706 words - 7 pages Running head: Financial Analysis of Starbucks University of Houston-Victoria School of Business Administration FIN6352 – Financial Management Dr. Omar M. Al Nasser August 11th, 2013 Financial Ratios, Growth Analysis, Cost of Capital, Capital Structure, & Capital Budgeting Analysis For Starbucks Corp. Table of Contents Executive Summary……….………………………………………………………….………..3 Capital

Report On Capital Structure And The Cost Of Capital Of Astrazeneca Plc And British American Tobacco Plc

2868 words - 12 pages Report on Capital Structure and the Cost of Capital of AstraZeneca Plc and British American Tobacco Plc. Table of Contents 1.0 Introduction………………………………………… 4 2.0 Background………………………………………… 5 3.0 Capital Structure…………………………………… 6 3.1 Debt to equity……………………………… 6 3.2 Long term debt to equity…………………... 7 3.3 Total debt to capital………………………… 7 3.4 Long term debt to

Risk Free Interest Rate

1108 words - 5 pages CHAPTER 12: COST OF CAPITAL A. OVERVIEW Definition: Cost of capital refers to the rate of return • a firm must earn on its investment projects to increase the market value of its common shares • required by market suppliers of capital to attract funds to the firm Notes: • If project rate of return > cost of capital ( value of firm increases • If project rate of return < cost of capital ( value of firm decreases


532 words - 3 pages period 3. Ignores the time value of money 4. Ignores the risk of future cash flows Discounted Payback Period Advantages Disadvantages 1. No concrete decision criteria that indicate whether the investment increases the firm's 1. Considers the time value of money value 2. Considers the riskiness of the project's 2. Requires an estimate of the cost of capital in order to calculate the payback cash flows (through the cost of

Medical Associates

574 words - 3 pages capital structure calls for 50% debt financing, the interest rate required on the business’s new debt is 10%, and its tax rate 40% 1. Calculate Medical Associates cost of equity estimate using the DCF method. Using the DCF method: Cost of Equity = D1/ PO + G D1 = expected dividend = DOX (1 + g) = 2X 1.07 =2.14 PO current price = $23 G = growth rate = 7% Cost of Equity = 2 x 14/23 + 7% = 16.30% 2. Calculate the cost of equity estimate

Related Papers

Nike Cost Of Capital Essay

814 words - 4 pages Nike Inc.: Cost of Capital We reviewed Joanna’s memo estimating Nike Inc.’s cost of capital and wanted to express our thoughts on the methods, assumptions, and conclusions utilized in her analysis. While we agree with some of the fundamental assumptions & methods, we have concerns about several others. We agree with using a single cost of capital, as the mix of product lines & business units don’t represent a material enough variance in

Nike, Cost Of Capital Essay

2240 words - 9 pages Nike Inc.: Cost of Capital Case #14 BUS 5200 Dr. Zong By Bryan Cooley, Esther Ferris, Jaime Lomeli and Aamir Syed Company Overview Nike Inc., founded in 1962, has evolved from an importer of Japanese shoes as a U.S. footwear distributor to a global marketer of athletic footwear, apparel and equipment that is unrivaled in the world. Nike has a powerful brand Portfolio with many solely owned subsidiaries that include Cole Haan, Converse

Cost Of Capital Essay

648 words - 3 pages Week 5 Cost of Capital Video Pfizer corporation is a research based pharmaceutical company in fact they are the world’s largest. They develop their own products, in a risky environment where a new product may have hundreds of millions of dollars invested in it and may fail and not be a viable product. Development of these types of products causes some significant cost of capital challenges for Pfizer. Pfizer’s capital structure like many

Nike, Inc Cost Of Capital Essay

2756 words - 12 pages Nike, Inc.: Cost of Capital Case 14 Kristopher Korzi Meilin Liu Paul Chen Selcuk Karahan 03/03/2011 CASE OVERVIEW Kimi Ford is a portfolio manager at a large mutual-fund management firm called, NorthPoint Group. Ford is considering the addition of Nike Inc. to the Large-Cap Fund at NorthPoint Group. Nike’s share price has notably declined since the beginning of the year. Her decision whether or not to add Nike to the portfolio