CAPM

Cost of Equity

Introduction

The Cost of Equity is calculated using the capital asset pricing model. The capital asset pricing model is donated by the following equation:

Cost of Equity = RF + Beta {RM - RF}

Cost of Equity is an extremely important value for any financial manager because this value, along with the Cost of Debt, is used to calculate the Weighted Average Cost of Capital (WACC) for any firm. The WACC is then used as a benchmark for investor decisions. For example if any project's predicted Annual Rate of Return (ARR) is below the company's WACC, then that project will not add any value to the firm; hence, that project will be rejected. The breakup of the Capital Asset Pricing Model's equation is as follows:

RF is the risk free rate which is usually denoted by the yield Government Securities that has a maturity of one year. Beta is the risk of a firm donated by the sensitivity of an investor's return on that firm's stock as compared to its benchmark, which, in our case, is the S&P 500. RM is the market's return and is calculated using an entire index's return over a particular period of time such as over 3 years. We can use the geometric mean of the 3 year's return to estimate the annual return of the entire market.

Discussion

The company I have chosen to conduct this study on is Wal-Mart Stores, Inc (WMT). Wal-Mart, a retailing giant, went public on 1972. It has the 3rd high market capitalization with a net value of approximately $241 billion. It also has the 3rd highest revenues among all companies with revenues exceeding $450 billion. Based on such numbers, Wal-Mart can be considered a safe option for various investors.

Calculation

Using the United States Department of the Treasury website, I found that the yield on a 1 year treasury bond was 0.2%. This value will be used as RF. To calculate RM, we will take the value of the S&P 500 3 years ago, and the value today, and then calculate the estimated RM for the S&P 500. The value 3 years ago was 1042 (Bloomberg, 2009) and the value today is 1414 (Bloomberg, 2012). Geometric Mean of the 2 values will be (1414 / 1042) ^ 0.333 - 1 = 0.107 or 10.7%. Wal-Mart's beta was found out to be 0.42 (Yahoo, 2012).Using the values above, we can calculate the Cost of Equity for Wal-Mart. The calculation is as follows:

Cost of Equity = 0.2% + 0.42 (10.7% - 0.2%)

Cost of Equity = 4.6%

Learning Outcomes

The Cost of Equity was calculated using the methodology mentioned above. This value (4.6%) was in line with my expectations of Wal-Mart's Cost of Equity. As mentioned earlier, Wal-Mart is a giant retail industry with one of the highest market capitalizations and revenues in the entire world. In addition, a retailing business is far less risky than other business models such as an IT business model or a financial services ...