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Tutorial 7 Solutions Stat3021 Usyd

The document discusses the cost of capital, specifically focusing on the cost of equity and its calculation using the Capital Asset Pricing Model (CAPM). It explains key concepts such as the risk-free rate, equity market risk premium, and the distinction between levered and unlevered beta. Additionally, it provides a practical example of calculating a proxy beta and determining the cost of equity for a company using given financial data.

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nathan zhou
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29 views3 pages

Tutorial 7 Solutions Stat3021 Usyd

The document discusses the cost of capital, specifically focusing on the cost of equity and its calculation using the Capital Asset Pricing Model (CAPM). It explains key concepts such as the risk-free rate, equity market risk premium, and the distinction between levered and unlevered beta. Additionally, it provides a practical example of calculating a proxy beta and determining the cost of equity for a company using given financial data.

Uploaded by

nathan zhou
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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FINC3015

Tutorial 7 Questions
1. Discuss what a firm’s cost of capital represents
A firm’s cost of equity is the rate of return required by a company’s common shareholders. It represents the
opportunity cost of investing in said business for an equity investor. For example, if a firm’s cost of equity is
8%, that means that the investor has other investments opportunities of similar risk available that also yield 8%.

2. How do we calculate a firm’s cost of equity?


The estimation of the cost of equity is challenging because of the uncertain nature of future cash flows in terms
of the amount and timing. The most widely used method of estimating the cost of equity is the capital asset
pricing model (CAPM).
In the CAPM approach, we use the basic relationship from CAPM theory that the expected return on a stock is
the sum of the risk-free rate of interest and a premium for bearing the stock’s market risk.

The three variables include the risk-free rate, a firm’s beta and the market’s return. Investors expect to be
compensated for risk and the time value of money. The risk-free rate in the CAPM formula can be thought of
as accounting for the time value of money. The other components of the CAPM formula account for the investor
taking on additional (equity market) risk on top of the risk-free rate

3. What does a risk-free rate represent?


The risk-free rate represents the return of a risk-free asset (no default risk). Given that there is no financial
asset that is truly risk-free, a common proxy for the risk-free rate is the yield on a default-free (AAA rated)
government debt instrument. In general, the selection of the appropriate risk-free rate should be guided by
the duration of projected cash flows. If we are evaluating a project with an estimated useful life of 10 years,
we may want to use the rate on the 10-year Treasury bond (US).

4. What does the equity market risk premium represent?


The expected market risk premium is the premium that investors demand for investing in a market portfolio
relative to the risk-free rate. When using the CAPM to estimate the cost of equity, in practice we typically
estimate beta relative to an equity market index. In that case, the market premium estimate we are using is
actually an estimate of the equity risk premium.
There are several ways to estimate the equity risk premium.
1. First is the historical ERP approach. This approach requires compiling historical data to find the average
rate of return of a country’s market portfolio and the average rate of return for the risk-free rate in
that country, and finding the difference
2. Second is the survey approach. You ask a panel of finance experts for their estimates and take the
mean response. Here we are assuming that finance experts have more information on equity risk
premiums than the average person / investor, and thus their ERP estimates are what underpins asset
prices in today’s markets.

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5. Discuss the practical application of the CAPM in the real world. Does the model capture all
business risks that should be reflected in a firm’s cost of equity?
The estimations of variables such as the risk-free rate, return on market can be quite subjective:
• Risk-free rate, choice of government security, duration, duration of time series data
• Return on market – historical average or geometric average, what risk-free rate and what market
portfolio, duration of time series data
• Beta – different methods to compute, sometimes need to calculate a proxy beta which may not reflect
the systematic risk of the company / project at hand
CAPM is also built on the assumption that investors can readily lend and borrow at the risk-free rate. Individual
investors in reality are unable to borrow at the same rate as the US government.
CAPM also assumes that investors are only interested in knowing the rate of return for a single period, and we
use this CAPM to generalise a cost of equity over an entire forecast period.
Additionally, there may be additional factor risks that are not captured by the CAPM (risks for which investors
demand compensation for that are not solely market risk e.g. macroeconomic factors). In that case, multifactor
models may help capture more risk factors that aren’t reflected in the CAPM model.

6. What is the difference between a levered and unlevered beta?


Beta is a measure of a stock’s sensitivity to movements in the broader market. Levered and unlevered beta are
two different types of beta, in which the distinction is around the inclusion (or removal) of debt in the capital
structure.
Unlevered beta measures the market risk of a company without the impact of debt – thus isolating the risk due
solely to the company assets. Comparing companies’ unlevered betas gives an investor clarity on the
composition of risk being assumed when purchasing the stock. When a company’s D/E ratio increases, this leads
to a larger percentage of earnings being used to service that debt which amplifies investor uncertainty about
future earnings streams. Consequently, the company’s stock is deemed to be getting riskier. This increased risk,
however, is due to financial leverage risk rather than market risk, and therefore we must unlever beta before
it is comparable across companies.
Since companies have different capital structures and levels of debt, an investor can calculate the unlevered
beta to effectively compare them against each other or against the market.

7. Using the information provided below, compute a proxy beta for Pilatus Ltd.

Pilatus Ltd. D/E = 40%

Alpha D/E = 55% Levered beta: 1.3

Charlie D/E = 80% Levered beta: 0.9

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FINC3015

Delta D/E = 34% Levered beta: 0.7

Alpha unlevered: 1.3/(1+((0.7)*0.55)) = 0.94


Charlie unlevered: 0.9/(1+((0.7)*0.8)) = 0.58
Delta unlevered: 0.7/(1+((0.7)*0.34)) = 0.57
Median: 0.58.
Pilatus levered beta = 0.58*(1+((0.7)*0.4)) = 0.74

8. Dell issued a fixed-rate preferred stock three years ago and privately placed it with institutional
buyers. The stock was at $50 per share with a $1.75 dividend. If the company were to issued
preferred stock today, the yield would be 3 percent. The stock’s current value is: $58.33 – if it paid
a $1.75 dividend previously and the yield is now 3%, ceteris paribus the stock’s value would be
higher than it was when the dividend was issued previously. Using the CAPM model, what is
Dell’s cost of equity?
Equity risk premium 5.35%
Risk-free rate 2.34%
Dell’s Debt/Equity Ratio 124%
Corporate tax rate 35%
Dell’s equity beta 1.4
Dividends paid for FY21A $300m

Cost of equity = risk-free rate + beta * EMRP


Cost of equity = risk-free rate + ERP
Cost of equity = 2.34% + 5.35% = 7.69%

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