MEAD CORPORATION: COST OF CAPITAL Case Solution
Using the Treasury securities as the risk free rate not yield the true value because they contains market risk as well as the inflation risk in them which also changes with different investment time period. Thus the best alternative which has the minimum or simply no risk theoretically in them are the treasury bills. These bills simply does not have the inherent market risk in them and the values of the 1 year, 5 years or the 10 years values could be considered very easily for them.
However, for the computation of cost of capital of Mead Corporation using the capital asset pricing model, the value of the risk free rate of the company is already given for the year 1990 to be 8.25% which is also the value of yield to maturity of a 30 year government T-bonds in the year 1990.
Market Risk Premium
Using the capital asset pricing model for the computation of cost of equity for the company, the other significant factor is the market risk premium. The value would be taken from the historical trends in the company. The investment analysis conducted by the value line indicated the fact that the company utilize a fixed market risk premium of about 6% which is basically the very conservative approach used by the company as compared to the value of risk premium of about 5.5% in the S&P 500 index.
It is relatively better to use the conservative approach in estimating the value of market risk premium that could also increase the cost of equity of the company for better evaluation of the overall project in times when the economic conditions of the country gets significantly disturbed. Thus, the value of 6% would be utilized for the further computation of cost of equity.
Second Risk Free Rate in the Formula:
From the formula of the capital asset pricing model, it can be seen that there are two risk free rates used. The knowledgeable investor before investing in any security requires higher return because of taking more risk. It can be seen from the formula that the required rate of return contains at least the risk which could he obtain from investing in the risk free investment and further it require return from the risk specific to the company.
In the given case the value of the two risks free rates in the formula are exactly the same and there is no any change in them. The value used for this risk free rate would be as given in the case to be 8.25%.
Computation of Cost of Equity:
The value of the cost of equity from the capital asset pricing model is computed by using the following formula:
Cost of Equity = Risk Free Rate + (Risk of the Market – Risk Free Rate) * Beta
By incorporating all the values in the given formula, the value of the cost of equity of the company is computed to about 16.6%. The significant reason behind the increase in the value of the cost of equity is because of the increasing value of beta used, using the risk free rate of 8.26% and the prevailing changing interest rate in the economy. However, the significant reason behind the increase is the company specific risk in relation to the market that is represented by Beta. This shows that the company is entering in the increased risk which illustrates the fact that the shareholders would now be demanding more return for taking this risk.
|Risk Free Rate||8.25%||Given|
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