2. Suppose the market portfolio has an expected return of 10% and a volatility of 20%, while Microsoft’s stock has a volatility of 30%.

A.Given its higher volatility, should we expect Microsoft to have an equity cost of capital that is higher than 10%?

No, Microsoft is diversifiable and it will not be affected by the changes in the market. We do not expect Microsoft’s equity cost of capital to be higher than 10%. Each stock carries its own weight.

B. What would have to be true for Microsoft’s equity cost of capital to be equal to 10%? In order for Microsoft’s equity cost of capital to be 10% its beta will have to be 1.

4. Suppose all possible investment opportunities in the world are limited to the five stocks listed in the table below. What does the market portfolio consist of (what are the portfolio weights)? Stock Price/Share ($) Number of Shares Outstanding (millions) A 10 10

B 20 12
C 8 3
D 50 1
E 45 20

Total value of the market = 10x10+20x12+8x3+50x1+45x20= $1.314 billion Stock Portfolio Weight
A 10x10=100 100/1314 =0.0761 x 100 = 7.61% B 20x12= 240 240/1314 =0.1826 x 100= 18.26% C 8x3= 24 24/1314= 0.0183 x 100 = 1.83% D 50x 1 = 50 50/1314=0.03381 x 100 = 3.81% E 45x20 = 900 900/1314= 0.6859 x 100 = 68.49%

Total = 100%

5. Using the data in Problem 4, suppose you are holding a market portfolio, and have invested $12,000 in Stock C.

...Cost of equity refers to a shareholder's required rate of return on an equityinvestment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk.
How It Works/Example:
The cost of equity is the rate of return required to persuade an investor to make a given equityinvestment.
In general, there are two ways to determine cost of equity.
First is the dividend growth model:
Cost of Equity = (Next Year's Annual Dividend / Current Stock Price) + Dividend Growth Rate
Second is the Capital Asset Pricing Model (CAPM):
ra = rf + Ba (rm-rf)
where:
rf = the rate of return on risk-free securities (typically Treasuries)
Ba = the beta of the investment in question
rm = the market's overall expected rate of return
Let's assume the following for Company XYZ:
Next year's dividend: $1
Current stock price: $10
Dividend growth rate: 3%
rf: 3%
Ba: 1.0
rm: 12%
Using the dividend growth model, we can calculate that Company XYZ's cost of capital is ($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%) = 12%
Why It Matters:
Cost of equity is a key component of stock valuation. Because an...

...
Equity
In accounting and finance, equity is the residual value or interest of the most junior class of investors in assets, after all liabilities are paid; if liability exceeds assets, negative equity exists. In an accounting context, shareholders' equity (or stockholders' equity, shareholders' funds, shareholders' capital or similar terms) represents the remaining interest in the assets of a company, spread among individual shareholders of common or preferred stock; a negative shareholders' equity is often referred to as a positive shareholders' deficit. At the very start of a business, owners put some funding into the business to finance operations. This creates a liability on the business in the shape of capital as the business is a separate entity from its owners. Businesses can be considered, for accounting purposes, sums of liabilities and assets; this is the accounting equation. After liabilities have been accounted for, the positive remainder is deemed the owners' interest in the business. This definition is helpful in understanding the liquidation process in case of bankruptcy. At first, all the secured creditors are paid against proceeds from assets. Afterwards, a series of creditors, ranked in priority sequence, have the next claim/right on the residual proceeds. Ownership equity is the last or residual claim against assets, paid only after all other creditors...

...|
Table of Contents
Cost of Capital 2
Value of Equity 2
Cost of Equity 2
CAPM Model 2
Dividend Growth Model 3
Value of Debt 3
Cost of Debt 4
WACC (Weighted Average Cost of Capital) 4
Comparison to Joanna Cohen’s Analysis 4
Financial Statement Analysis 5
Nike Inc. 5
Financial Ratios 6
Leverage Ratios 6
Efficiency Ratios 6
Liquidity Ratios 7
Profitability Ratios 7
Valuation Ratios 7
Conclusion 8
Appendix A – Ratio Calculation 9
Leverage Ratios 9
Efficiency Ratios 9
Liquidity Ratios 9
Profitability Ratios 10
Valuation Ratios 10
Cost of Capital
Value of Equity
Cohen's calculation considered the book values to calculate the proportion of equity for calculating the value of WACC which should only be done if the target or market values are not available. In order to determine a more realistic cost of equity, it is recommended to use the market value. The current market share price of Nike as of 2001 is $42.09 and there are 271.5 total shares outstanding.
Therefore the market value of equity is:
Current share price * Average shares outstanding: (42.09 * 271.5) = $11,427.44 million
This figure is much higher than the book value of $3,494.5 million that Cohen used to calculate the value of equity.
Cost of Equity...

...will receive this report, and based on the findings and analysis included, Apple will be given a recommendation as to the costequity model they should implement to estimate their future rate of returns.
This report will discuss the accuracy and ease of use of these three models. The main consideration will be determined by how realistic each model is at developing the assumed rate of return.
Part 2 of this paper will discuss the cost ofequity or discount rate based on hypothetical data to be calculated using the CAPM model. Considering the information presented, the cost of equity for each company will be explained and what factors influence company beta.
I will explain how to apply dividend growth when estimating the cost of equity of stable companies. I will show my understanding of APT and how it relates to CAPM and dividend growth, while also applying CAPM to estimate the rate of return that a company’s investors require.
In conclusion I will reiterate what I perceive to have learnt as well as give my evaluation of the module 3 case assignment.
Part I
Report to Apple Board of Directors
Apple stock has been extremely stable with a beta of .74 and that number has probably risen in the last six months since Apple stock has gone into a negative trend for the first time in many years. Apple has not held any debt so there is no...

...CHAPTER 14
The Cost of Capital for Foreign Investments
EASY (definitional)
14.1 The ________ for a given investment is the minimum risk-adjusted return required by the shareholders of the firm for undertaking that investment.
a) cost of equity capital
b) systematic risk
c) all-equity beta
d) weighted average cost of capital
Ans: a
Section: The cost ofequity capital
Level: Easy
14.2 One function of the cost of capital is to _______ for the firm.
a) determine the debt to equity ratio
b) value future cash flows
c) determine the current ratio
d) determine the current lending rate
Ans: b
Section: The cost of equity capital
Level: Easy
14.3 According to modern capital market theory an equilibrium relationship exists between an asset’s required return and its associated risk, which can be represented by the _______ model.
a) risk-return tradeoff
b) capital asset pricing
c) purchasing parity
d) interest rate parity
Ans: b
Section: The cost of equity capital
Level: Easy
14.4 What is the outcome when the cost of equity capital is combined with after-tax cost of debt?
a) all-equity beta
b) cost of capital
c) weighted average cost of...

...1. How are Mortensen’s estimates of Midland’s cost of capital used? How, if at all, should these anticipated uses affect the calculations?
Mortensen’s cost of capital estimates are used for a variety of purposes at both the divisional and corporate levels. Examples include internal analyses such as financial accounting, performance assessment and capital budgeting, while others are used for strategic planning purposes such as merger and acquisition, as well as stock repurchase decisions (Luehrman and Heilprin, 2009, pg.1). When used at the divisional rather than corporate level, special consideration should be given to the fact that Midland’s divisions are not publicly traded entities, and therefore do not have individual Beta figures. In order to properly assess the cost of capital for Midland’s divisions, Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average of these estimates to derive a beta estimate for divisional beta estimates (pg.6).
2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why?
Midland’s corporate WACC is 9.17%. Please see exhibit 1 for supporting calculations. The risk-free...

...explain what you do and any assumption you make.
Risk Premium Estimation. Two approaches you could use to estimate the Equity Risk Premium:
* Assume that expected return on the market portfolio is related to a Macroeconomic variable, e.g., GDP. Then use the expected changes in the macroeconomic variable, with appropriate probabilities to estimate expected return on the market portfolio. Subtract the RFR from the expected return estimated and arrive at yourequity risk premium. Don’t forget to multiply this by the beta value.
* Implied equity premium. This assumes that the overall market is correctly priced.
The valuation model suggests value equals:
Value = Expected Dividends Next Period/ (Required Return on Equity - Expected Growth Rate)
This is the present value of dividends growing at a constant rate. We can obtain three of the four inputs in this model can be obtained externally:
* the current level of the market (value) of the index,
* the expected dividends next period, and
* the expected growth rate in earnings and dividends in the
long term.
The only “unknown” is then the required return on equity; when we solve for it, we arrive at an implied expected return on stocks. Subtracting out the risk-free rate will yield an implied equity risk premium (see Damodaran Website for more)
* Free Cash Flow to Equity model
*...

...Chapter 1
the equity method of accounting for investments
Chapter Outline
I. Three methods are principally used to account for an investment in equity securities.
A. Fair-value method: applied by an investor when only a small percentage of a company’s voting stock is held.
1. Income is recognized when dividends are declared.
2. Portfolios are reported at market value. If market values are unavailable,investment is reported at cost.
B. Consolidation: when one firm controls another (e.g., when a parent has a majority interest in the voting stock of a subsidiary or control through variable interests (FIN 46R), their financial statements are consolidated and reported for the combined entity.
C. Equity method: applied when the investor has the ability to exercise significant influence over operating and financial policies of the investee.
1. Ability to significantly influence investee is indicated by several factors including representation on the board of directors, participation in policy-making, etc.
2. According to a guideline established by the Accounting Principles Board, the equity method is presumed to be applicable if 20 to 50 percent of the outstanding voting stock of the investee is held by the investor. SFAS 159, The Fair Value Option for Financial Assets and Financial Liabilities...

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