We used the following framework to do the calculations for all the companies. Afterwards we will discuss their implications:
To estimate the cost of equity (RE) we used the following CAPM model: RE = RF + βE (RM-RF)
Market Premium = RM – RF = 6% (Given in case)
RM = Return for S & P 500 (a market return that takes into account systematic risk associated with the market place where our company is traded, NYSE) Risk Free Rate of Return = RF = US Treasury Yield (according to the time horizon we took the Yield Curve for US Treasury. This is the closest to a Risk Free Security since it is backed by the US Government and is perceived as so by the marketplace) RE = Return for the company in question we wish to analyze
βE = COV(RM ,RE)/VAR(RM)
To estimate the Cost of Capital (RA) we use a CAPM similar to RE but we use the beta of capital defined as: βA=(Debt/Assets)*βD+(Equity/Assets)*βE
This gives us the following model for the Cost of Capital (RA), similar to the model above: RA= RF + βA(RM-RF)
All the information was collected from finance.yahoo.com, except for the US Treasury yields which are listed above. We obtained stock quotes for the past 521 weeks to get 520 weekly returns (10 years) and used the pertinent intervals for the respective time horizons. For the Balance Sheets we used the information available on finance.yahoo.com; we utilized the most recent balance sheets for the 1 year horizon, 2007 balance sheets for 3 years, and so on. We did not find any other reliable source for ten year financial statements so we decided to assume that the Balance Sheet will remain the same in the past. We preferred to do this than to use information which could be incorrect or unreliable.
1. Estimate Cost of Equity (RE) and Cost of Capital (RA) for Toyota for 1, 3, 5 and 10 year window? Which horizon do you prefer?
Time Horizon (yrs)| 1| 3| 5| 10|
SnP500 Var| 0.000570464| 0.001361864| 0.000921782| 0.000720423| Covar (SnP500,TM)| 0.00026442| 0.001065772| 0.000757171| 0.000573121| Beta E (TM)| 0.46 | 0.78 | 0.82 | 0.80 | RE TM (Cost of Equity)| 3.06%| 5.47%| 7.12%| 7.61%|
Using the previous methodology we looked for the information online and calculated the RE for Toyota, and then calculated the Cost of Capital: Time Horizon (yrs)| 1| 3| 5| 10|
Beta E (TM)| 0.46| 0.78| 0.82| 0.80|
D/A TM| 0.64| 0.64| 0.64| 0.64|
E/A TM| 0.36| 0.36| 0.36| 0.36|
Beta A TM| 0.33| 0.44| 0.46| 0.45|
Ra TM (Cost of Capital)| 2.24%| 3.43%| 4.94%| 5.53%|
In practice we prefer to use a 5 year horizon. This takes into account the business cycle that the company can endure (i.e. cyclical factors, depression or a bull market), but is not long enough that the business model of the company will change over time. If we take into account one year or three years, we risk the possibility of taking into account a period of time when there is a depression or the business is in the lower or higher part of its cycle. This may result in a return which doesn’t reflect the real cost for the company, just the cost in a specific time. If we take 10 years we run the possibility that the company will change its revenue model and we consider 5 years is more than enough to capture a normal business cycle.
2. Assume that Toyota is a private company. Estimate the Cost of Capital and Equity following the provided steps.
We use two parameters to find comparable companies to Toyota (NYSE:TM): the industry where the company competes and the exchange where the stock is traded. This eliminates some obvious global car manufacturers such as Volkswagen, Nissan or Fiat since these companies aren’t traded on the NYSE. Companies that best fit the criteria were Ford (NYSE: F), Honda (NYSE: HNDA) and GM. We could not use GM though as it was delisted...