WHAT IS THE COMPANY’S COST OF EQUITY IF THE CURRENT STOCK PRICE IS 40.84 PER SHARE
The correct answer and explanation is:
To calculate a company’s cost of equity, the most common approach is to use the Capital Asset Pricing Model (CAPM). The formula for CAPM is: Cost of Equity=Rf+β×(Rm−Rf)\text{Cost of Equity} = R_f + \beta \times (R_m – R_f)
Where:
- RfR_f = Risk-free rate (typically the yield on government bonds, like U.S. Treasury bonds)
- β\beta = Beta (a measure of how much the company’s stock price fluctuates compared to the market as a whole)
- RmR_m = Expected market return (average return expected from the overall market)
To use this formula, we would need the following information:
- The risk-free rate: This is usually obtained from the yield on a government bond (e.g., a 10-year Treasury bond).
- The beta (β) of the company: This can be found from financial data providers such as Yahoo Finance, Bloomberg, or Reuters. It indicates the company’s volatility in relation to the market. If β is greater than 1, the stock is more volatile than the market, and if it is less than 1, it is less volatile.
- The market return: This is the expected return from the market, typically based on historical performance. The average market return has historically been around 7-10% per year.
Example Calculation (using hypothetical values):
Assume the following:
- The risk-free rate (R_f) is 2% (0.02).
- The beta (β) is 1.5.
- The market return (R_m) is 8% (0.08).
Using the CAPM formula: Cost of Equity=0.02+1.5×(0.08−0.02)\text{Cost of Equity} = 0.02 + 1.5 \times (0.08 – 0.02) Cost of Equity=0.02+1.5×0.06=0.02+0.09=0.11 or 11%\text{Cost of Equity} = 0.02 + 1.5 \times 0.06 = 0.02 + 0.09 = 0.11 \text{ or } 11\%
Therefore, the cost of equity in this example would be 11%.
This means that the company needs to generate a return of at least 11% on its equity to satisfy its investors and compensate for the risk they are taking by investing in the company’s stock.