First find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year or 13 weeks Treasury Bill Rate
That rate is the "risk-free rate."
Next, it is customary to assume that the difference between the expected rate of return on the "market portfolio" and the risk-free rate of return is about 5.0%. This is the expression [RM - RF]. So, if for example, the risk-free rate of interest is, say, 1% per year, then the expected rate of return on the "market portfolio," RM, is 6%. So, multiply the "beta" of your SLP Company by 5.0%. That will be the equivalent of your company's βj [RM - RF]. Then add to that number the current yield to maturity on a US Government bond [see step (1) above]. You are free to try to research and find more up to date values of RM and RF, but to simplify this assignment you can also assume that RF = 1, RM =5 and [RM - RF]= 4.
The above procedure provides you with an estimate of the rate of return that the shareholders of your SLP Company require on their investment. This rate is called the cost of equity of your company.
After showing all calculations
Answer the following Assignment questions:
Show your work that you used to obtain the cost of equity for Raytheon company.
2) Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 8.2 percent. Would you think your firm should have a lower or a higher cost of capital than the average firm?
3) Look up the betas for some of the other companies compared to RAYTHEON
Lockheed Martin BETA= 0.61
CACI International Inc Beta = 1.35
Using these betas, compute the cost of equity for these firms. How do they compare to Raytheon company? Are you surprised that some firms have a higher or lower cost of equity than Raytheon
Important:
4) How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for Raytheocompany? Don't worry, you don't actually have to do any calculations - just explain how you would go about doing these calculations and explain what kind of additional information you might need.
5) What do you perceive you have learnt
- Apply the CAPM to estimate the cost of equity of a publicly traded company, or the rate of return that its investors require
- Derive, examine and explain the relationship between the systematic risk coefficient on the company's operations ('asset beta'), the systematic risk to its shareholders ('equity beta') and the relationship of both concepts to the debt/equity ratio of the company
- Understand and explain Arbitrage Pricing Theory and its relationship to the CAPM and dividend growth model
- Explain the possible application of the dividend growth model and apply it in order to estimate the implicit cost of equity of a mature, stable company