The Cost of Equity Capital and the CAPM, Corporate Finance

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Part II

The cost of equity (discount rate) can also be determined by using the Capital Asset Pricing Model (CAPM). Calculating the cost of equity using the CAPM model is often more difficult than using the dividend discount model. The companies’ financial statements do not show the cost of equity.

The following table shows necessary (hypothetical) information to calculate the cost of equity by using the CAPM model:

Company
Listing
RRF
RM
ßj

Nike Inc.
NYSE: NKE
0.40%
6.50%
0.90

Sony Corporation
NYSE: SNE
0.40%
9.50%
1.60

McDonald’s Corporation
NYSE: MCD
0.40%
8.50%
0.40


E(rj)= RRF + ßj (RM - RRF)

E(rj) - The cost of equity

RRF - Risk-free rate of return

ßj - Beta of the security

RM - Return on market portfolio

1.Based on the above information, which company has higher cost of equity? Why? Briefly explain your reasoning.
The CAPM model shows that risk-free rate of return, return on market portfolio, and company beta determine the cost of equity.

What type of factors influence company beta? Briefly describe the factors that influence company beta. For example, higher financial leverage (total liabilities to total assets ratio) can lead to higher company beta.

NOTE: Your report/assignment will not be accepted without proper citations and references. You must use the sources from the background material together with the sources you find on your own. It is also required that you answer all the questions related to learning outcomes.

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