Risk and Return Portfolio Diversification and the Capital Asset Pricing Model the Cost of Equity

Finance

Assessing WalMart Cost of Equity

Cost of Equity Using CAPM

To calculate the cost of equity using the capital asset pricing model (CAPM), the equation requires collection of some data regarding the firm and the market. The equation tells us what data is needed, the equation is cost of equity = RF + ?(RM - RF). RF is the risk free rate, RM is the return on a market portfolio, and ? is the beta.

The equation starts with the requirement to determine the risk free rate (RF). The risk free rate is usually the current rate for government bonds. There is some flexibility here, as government bonds are issued over different periods, a common term used is the one year bond rates. The current rate given for 20th December 2013 is 0.13% (U.S. Department of Treasury, 2013).

The next input is the return on the market portfolio. This is assumed to be 5%. The last input is the beta, this is a measure or volatility or risk; a beta of one means the volatility of the share matches that of the stock market, if it is higher it is more volatile, a lower figures means it is less volatile. The beta for WalMart is 0.3 (Yahoo Finance, 2013), meaning the share is less volatile compared to the stock market.

Risk free rate = 0.13%

Return on market portfolio = 5%

Beta = 0.3

With the relevant information it is now possible put together the equation which will give the expected return on equity.

0.13% + 0.3(5% - 0.13%) = 1.591%

This gives the cost of equity being 1.591%

Question 2 - Assessing the Cost of Equity

The result of 1.591% may be seen as lower than expected. The low rate or return is due to the very low beta. WalMart has a low beta as the share price is very stable, and this reflects a potentially lower level of risk. The higher the risk, the higher the expected rate of return due to the risk premium; the risk premium is the potential reward for investors taking the risks. As WalMart appears to offer little risk to the investor, the risk premium is very low. This may be surprising, especially if the current cost of capital for S&P 500 firms is 8.2%. The cost of capital is made up of the cost of equity and the cost of debt, but with the lower rate of risk associated with WalMart, as seen with the beta, one may expect this to be lower that the average S&P 500 company, where the average may be much higher due to the presence of very risky as well as safer firms.

Question 3 - Other Firms Cost of Equity

To assess any form it is often beneficial to compare the firm against similar firms in the same industry. For WalMart this may include Target and Sears, Target has a beta of 0.65, and Sears has a beta of 2.9. These can be used to assess the expected cost of equity for each firm.

For Target the equation is 0.13% + 0.65(5% - 0.13%) = 3.296%

For Sears the equation is 0.13% + 2.9(5% - 0.13%) = 14.253%

Target has a higher expected return on equity as it has a higher beta, but it is still below the average cost of capital which as been given as 8.2%. It may be surprising that Target has an expected return on equity which is twice that of WalMart, as the firms appear very similar. However, most surprising is the high level of expected return on equity for Sears, which is 14.253%, this is much higher, but the rate is a reflection of the beta. Knowing the share price moves it may be expected that Sears would have a higher expected return on equity.

Question 4 - Dividend Growth Model

An alternate approach is to use the dividend discount model to assess the cost of equity. The underlying assumption for the dividend discount model is that the value of a firms' share are equal to the discounted cash flow of the future dividends (Beck, 2013). The model is commonly used to assess the price of a stock given the known returns and expected growth rate, but it may also be used to assess the cost of equity (the returns). To calculate the expected return on equity the equation is (next years annual dividend/current price of stock) + dividend growth rate (Beck, 2013). Therefore, to perform this calculation it would be necessary to look at the firm performance, looking at the expected dividends and the rate at which they are expected to grow (Beck, 2013).