Thursday, 29 September 2016

[Solution] Do I use the =Rate formula if so I keep getting stuck

Do I use the =Rate formula if so I keep getting stuck

If the risk-free rate on a 10-year U.S.
Treasury bills is 3% and the expected rate of return on the overall stock market is 11%.

The company has a beta of 1.6.
What is the cost of equity? 

  


Do I use the =Rate formula if so I keep getting stuck

Anwsers to the Problem Do I use the =Rate formula if so I keep getting stuck

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Marcia wrote:
If the risk-free rate on a 10-year U.S.
Treasury bills is 3% and the expected rate of return on the overall stock market is 11%.  The company has a beta of 1.6.  What is the cost of equity?


"Cost of equity" (COE) is another term for "cost of retained earnings".  Refer to http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/cost-of-retained-earnings.asp#axzz1kWQbWIgC (click
here).

As noted there, there are 3 methods for determining COE.  In another one of your problems, we used the "discounted cash flow" method (aka "dividend yield plus growth" method).  Apparently, now your trainer wants you to use the CAPM method.

According to the investopedia webpage, the CAPM formula to use is:

COE = r[f] + B*(r[m] - r[f])

where:
r[f]    = risk-free rate, in your case the 10-year T-bill at 3%
r[m] = expected stock market return, 11% in your case
B     = beta of the stock, 1.6 in your case

Put r[f], r[m] and B into separate cells, e.g.
A1, A2 and A3.

Then put the formula =A1+A3*(A2-A1) into a cell to compute COE, and format as Percentage with 2 or more decimal places.

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