Southwest Airlines the Capital Asset Pricing Model

Southwest Airlines

The capital asset pricing model (CAPM) is a method that is commonly used to determine the cost of equity for a company. The formula for CAPM is:

Investopedia (2012)

According to MSN Moneycentral (2012), the beta for Southwest Airlines is 1.13.

The risk free rate, based on the one-year Treasury yield, is 0.17% at present (U.S. Department of the Treasury, 2012). We are assuming a 7% market risk premium, as is customary.

This results in a CAPM calculation as follows:

Ra = Rf + ? (Rm-Rf)

Ra = 0.17 + (1.13) (7)

Ra = 0.17 + (7.91)

Ra = 8.08%

Therefore, according to CAPM, the cost of equity for Southwest Airlines is 8.08%.

This cost of equity is about what would be expected. Southwest is a relatively stable firm that seldom has massive swings in earnings, despite being an airline. If the historic average cost of capital for a firm in the S&P 500 is 10.2%, then Southwest falls below that. However, this is linked to the fact that the risk free rate is very low at present. The risk free risk is not historically near the zero bound. Because the risk free rate is so low right now, the cost of equity for most firms will be below their historical averages. For example, if we take 3% as the risk free rate -- a more reasonable number historically -- we can see that the cost of equity for Southwest is 3 + 7.91 = 10.91%.

We would assume that the 10.2% figure is for a beta of 1.0, because the beta is the correlation with the market. Thus, Southwest would have a cost of equity higher than the average market cost of equity by the fact that it has a beta above one. Having some added degree of firm-specific risk makes Southwest a slightly riskier stock overall than the market, necessitating a higher rate of return.

The dividend growth model is based on the current dividend, the dividend growth rate and the current stock price. To calculate the cost of equity using this model, simply gather those variables and plug them into the formula:

Source: Wikipedia