Estimating the Cost of Equity Capital
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Estimating the Cost of Equity Capital

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Estimating the Cost of Equity Capital


This chapter reviews the inputs to the build-up model for estimating the cost of common eq­uity capital, thus saving you from the necessity to look for experts in this field via job search sites.

1. The typical build-up model for estimating the cost of common equity capital may consist of all of the following components EXCEPT:

a.  A risk-free rate,


b.  "Beta.


c.   A general equity risk premium.


d.  A size premium,


2- The risk-free rate component of the build-up model re fleets which of me following components?


T-     Rental rate.


II. Inflation.


III. Default risk.


TV. Maturity or investment risk, a. I, 11, 111


b.  i, in, rv


c.  am,iv


d. I. 11. TV


Build-up Models

3.   Which of the following are reasons why financial analysts prefer the 20-year U.S. Treasury yield to maturity as the risk-free rate in the build-up method?


I.    It approximates the assumption of perpetuity for an equity investment.


3.1.   Shorter-term rates fluctuate less than longer-term rates.


III. Longer-term yields fluctuate less than shorter-term ones.


IV. Longer-term yields contain maturity risk.


a.   J, 13, JII


b.  1, III, IV


c.   ILIILIV


d.  1,11,1V


4.   All of me following are factors that may impact company-specific risk EXCEPT:


a.  Volatility of returns


b.  General equity risk premium


c.   Leverage


d.  Size smaller than the smallest size premium grou


5. U.S. Treasury obligations with maturities of 1, 10, and 20 years typically are used to represent the risk-free rate in the build-up model for estimating the cost of equity capital.


6. The view that the long-term arithmetic average equity risk premium is me best, proxy for today's equity risk premium is universally accepted.


7. An alternative to using the historical average equity risk premium data (lbbotson data) to estimate (he current equity risk premium is the discounted cash flow method.


8. it is empirically proven that the degree of risk and the cost of capital increase with decreasing company size.


9. The differential in expected return on tlie lions is called stock market over U.S. Treasury obliga-


10. A common method of estimating the equity risk premium is to use.


data.


tatically, the geometric mean is always mean, unless all observations are than the arithmetic


12. The cost of equity capital can be regarded as composed of two major components: a


rate and a premium.


13. When applying the build-up method in an international setting, a country.........


may be added to reflect uncertainties in the particular country. p model for estimating tlie cost of equity k The risk-free rate component of the include inflation. The following are annual returns on tlie stock market (as measured by a index) and on short-term U.S. Treasury obligations for five consecutive years).


Returns on tlie Market


on U.S.


nations


43%


15%


20%


-30%



6% 2% 5% 6%



15. Compute tlie short-term arithmetic mean equity risk premium over the five years of given.


16. Compute the short-term geometric mean risk premium over the five years of data given.


17.  Use the build-up method to calculate tlie cost of equity capital for Company XYZ using tlie following known variables:



Risk-free rate


Equity risk premium


Size premium for Company XY?


Company-specific risk premium


Despite many criticisms, the Capital Asset Pricing Model (CAPM) is still widely used to estimate the cost of equity capital, especially for large companies. This chapter reviews the in­puts to CAPM, differentiates between systematic and unsystematic risk, and presents an cx-


1. Compared to the traditional CAPM model, the expanded CAPM model includes which of the additional following factors?


a. Beta and the general equity risk premium for the market.


b. Risk-free rate, risk premium for small size, and company-specific risk.


c. Risk premium for small size and company-specific risk premium.


d. Risk-free rate, beta, and the general equity risk premium for the market.


2. A stock that pays no dividends has a beta of 1.4 and the market is down 10%. The beta for the market is considered to be equal to 1.0, According to CAPM, the price of the stock will be expected to:


a. Be up 14%.


b. Be up 10%.


c. Be down 10%.


d. Be dow7n 14%,


3. A stock trial pays no dividends has a beta of 0.75 and the market is down 10%. The beta for the market is considered to be equal to 1.0, According to CAPM, the price of the stock is expected to:


a. Be down 7.5%.


b. Be up 7.5%.


c. Be up 10%.


d. Be dow7n 10%,


Capital Asset Pricing Model 27


4. The risk that CAPM assumes is diversified away by investors holding well-diversified
portfolios is:


a. Systematic risk.


h. investment risk.


c. Default risk.


d. Unsystematic risk,


5. The equity risk premium for a security equals:


a. The security's beta limes a general equity risk premium for the market as a whole.


b. The beta for the market as a whole times a general equity risk premium for the market


as a whole.


c. The risk-free rate plus the product of the security's beta and the general equity risk pre­
mium for the market as a whole.


d. The security's beta or systematic risk.


6. The unsystematic risk of an investment in a particular company is a function of:
T. The characteristics of the industry.


II. The characteristics of the company.


III. 'i'he systematic risk of the investment.


IV. The type of investment interest.


a. I? IL III


b. I, 11, IV


c. run, iv


d. i, in, iv


7. Beta measures:


a. Unsystematic risk.


b. The general equity risk premium,


c. Systematic risk.


d. The specific (company) equity risk premium.


Generally, for a security, a higher beta signifies higher systematic risk and results in a higher estimated equity risk premium and cost of equity capital.


Since privately held companies have no market price, their betas can be directly observed and measured.


A fundamental assumption of CAPM is that investors do not require compensation for lhe systematic risk because they can easily diversify it away.


For a security with a beta lower than 1.0, when market rates of return move up or down, the rates of return for the subject security tend to move in the opposite direction and with lower magnitude.


12. One difference between the build-up method and CAPM is the introduction of ______________ as a modifier to the general risk premium.


13. . measures the sensitivity of excess total returns on any individual secu­ rity to (be total excess returns on some measure of the market, such as (he New York Stock Exchange (KYSH) Composite Index or the Standard & Poor's (S&P) 500 Index.


14. CAPM concludes that Lhe equity risk premium for a security is a linear function of the se­curity's .


15. For a security with a beta higher than 1.0, when market rates of return move up or down, (he rates of return for the subject security tend to move in the_______________ and with magnitude.


The following are known:


Risk-free rate as of the valuation date (Rf): 6%


Beta for security XYZ (BY 1.5


w.


Equity risk premium for the market as a w7hole (RP^Y


1.6. Compute the equity risk premium for security XYZ.



1 7. Compute the expected return (cost of capital) for security XYZ based on CAPM.



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