Question No. 4
Cost of Equity
The cost of equity is calculated with the formula of Capital Asset Pricing Model. The cost of equity gives us the value that the shareholder of the company requires in order to invest equity in the company. And as the rate of return that the investor requires is associated with the level of risk of the investment, thus, it is computed with the historical values of volatility of returns.
CAPM is the best option available to the company as the other method for the calculation of cost of equity is the dividend growth model and that requires a company to pay dividends. Thus, the calculation of cost of equity is done by using the formula of CAPM.
This formula requires two values of risk free rate, beta and market return.
The value of the first risk free rate is taken from the case study, i.e. 8.25 percent and the value of Beta is also suggested in the case study for the calculation of WACC, it is equals to 1.14.
Question No. 5
Expected Return on the Market
For the expected return on the market, we have taken the value of S&P 500 arithmetic mean as it gives us the value of average market return from the year 1926 to 1990 and it would be best to use this. The value of average market return is 12.10 percent.
Question No. 6
Risk Free Rate
For the calculation of second risk free rate, we have taken the value of T-Bills, which is provided in the exhibit 2 and is 3.7 percent. It can be seen that in previous calculations of WACC, the company used the long term government bonds, but T-Bills are considered as the most risk free, therefore, we will use T-Bills instead of long term bonds.
Question No. 7
Weighted Average Cost of Capital
The Weighted Average Cost of Capital using all the above values is 0.1099……………
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