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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, please review the background material on the capital asset pricing model, the material on the dividend growth model, and arbitrage pricing theory. These models provide some insights and tools to estimate the rate of return that investors in our company â??requireâ? 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 explain the challenge of estimating or coming with a good â??feelâ? for the "cost of equity capital" or the rate of return that you feel Under Armour investors require as the minimum rate of return that they expect of require Under Armour to earn on their investment in the shares of the company.
A report for the board of directors on 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 JetBlue Airlines? Based on your analysis and findings, what would you recommend to the board of directors of JetBlue Airlines?
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
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 companiesâ?? 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
Ã?j
Nike Inc.
NYSE: NKE
1%
4.49%
0.91
Sony Corporation
NYSE: SNE
1%
6.83%
1.48
McDonaldâ??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)
Ã?j - Beta of the security
RM - Return on market portfolio)
Based on the above information, which company has higher cost of equity? Why?