Question

Develop a reasonable estimate or range of estimates for SDI's cost of equity capital (ks) using the CAPM method. Tony Biddle informed you that 20-year Treasury bonds currently yield 6.1 percent, while the yield on 90-day T-bills is 5.2 percent. You could look up current rates on these instruments in The Wall Street Journal or some similar publication, but if you do, think about whether other parameters (risk premiums, betas, and inputs to the DCF model) might have changed since other data in the case were determined.

Answer 1

CAPM model i.e. Capital Asset pricing model which is widely used for calculating cost of equity.

CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of systematic risk (otherwise known as or non-diversifiable risk) and that investors need to be compensated for it in the form of a risk premium.

"Basically how much extra you should for taking each % of risk".

Formula:

Cost of equity(security) = RF + Beta(RM - RF)

RF = Risk free rate (Risk free rate is normally the yield on long term government bonds.)

RM = Expected return from the market

Beta = Beta of the security( Risk factor) (Suppose if Beta is 1 than it means if market goes up by 10%, equity also goes up by 10% and vice versa)

Cost of equity - expected return from capital asset and it is a long term phenomena that how asset will react over his life.

As per the change in yield on government instruments, the RF component in the above formula changes and accordingly the cost of equity will change.