CASE STUDY 3: ESTIMATING THE COST OF CAPITAL

QUESTION 1:

a)b)c)

The Capital Assets Price Model (CAPM) is used to describe the relationship between risk and expected return and is often used to estimate a cost of equity (Investopedia, 2009). The cost of equity(COE) of the discount rate is: R = Rf + β*(E - Rf) (1) Rf = Risk free rate of return, usually U.S. treasury bonds β = Beta for a company E = Expected return of the market (commercial airlines market) (E - Rf) = Sometimes referred to as the risk premium

The following table shows the average annual arithmetic returns investors earned on various asset classes over the period 1900 to 2003. (Source: Table 7.1 in Brealey/Myers/Allen)

| Nominal Return | Real Return | Common Stocks | 11.7 | 8.5 | Long- term Government Bonds | 5.2 | 2.3 | Short-term Government Bonds | 4.1 | 1.1 | Consumer Price Index (Inflation) | 3.0 | |

Equity Risk Premium = Stocks – Long Bonds = 11.7% - 5.2% = 6.5% use with long Rf

Equity Risk Premium = Stocks – T-Bills = 11.7% - 4.1% = 7.6% use with short Rf

The following table shows the average annual arithmetic and geometric nominal returns investors earned on various asset classes over the period 1926 to 2002. (Source: 2003 Ibbotson Associates, Inc.)2 The data assumes reinvestment of all interest and dividend income and does not account for taxes or transaction costs. The average return represents an arithmetic average annual return. | Arithmetic Return | Geometric Return | Stocks | 12.2 | 10.2 | Long-Term Corporate Bonds | 5.9 | 5.9 | Long-Term Government Bonds | 5.8 | 5.5 | Short-Term Government Bills | 3.8 | 3.8 | Consumer Price Index (Inflation) | 3.1 | 3.1 |

At the time of the case, four main equity market risk premiums (EMRP) were used: Arithmetic Equity Risk Premium = Stocks – Long Bonds = 12.2% - 5.8% = 6.4%

Geometric Equity Risk Premium = Stocks – Long