Estimating the Cost of Equity Capital

Estimating the Cost of Equity Capital


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Capital Asset Pricing Model

18. The expected return in excess of the risk-free rate for security7 ABC is 12% and the equity risk premium for the market as a whole is 8%. Compute the beta for security X YZ.

This chapter focuses on beta estimation methodology In the context of the Capital Asset Pricing Model (CAPM). Topics to master in this chapter include the differences between sys­tematic and unsystematic risk, the factors that impact the beta measurement process, and how to compute levered and unlevered betas. The chapter also introduces some metliodologies em­ployed by ibbotson Associates in the calculation of its betas.

1. If betas for all guideline companies are not available from one source, the best solution is to use:

a. For each guideline company, an average beta computed from ail betas available from all sources.

b. For each guideline company, the most conservative value offered by various sources,

c. The source providing betas for the greatest number of guideline companies and do not use betas for the others,

d. For each guideline company, the median beta from all betas provided by various sources.

2. Which of the following is NOT one of the steps in adjusting for leverage differences be­ tween the public guideline companies and the subject private company?

a. Compute unlevered betas for guideline companies.

b. Compute an arithmetic average of the levered betas of the public guideline companies.

c. Decide where the subject company's risk would fall relative to guideline companies, as­ suming ail had 100% equity capital structures,

d. R el ever the beta for the subject company on the basis of one or more assumed capital

3. The unlevered beta for a highly leveraged company could be highly underestimated if the levered beta was measured over a period of low or no leverage.

4. Beta is a modifier to the equity risk premium in the buiid-up model and in CAPM to estimate cost of equity capital.

5. The length of the total period over which returns are measured is not a factor that has considerable influence on the beta measurement.

6. The process of estimating a levered beta for a private company involves computing an average levered beta for the guideline companies from published beta values and then levering it again with the capital structure of the subject private company.

7. There is empirical evidence that, over time, a company's beta tends toward its average beta.

8. Levered betas reflect two risk factors:__________ risk and______________ risk.

9. For a leveraged company, unlevered beta is always________ than the levered beta.

10. The Ibbotson (adjusted) beta calculated by Ibbotson Associates is computed by a teclmique called______________________________________________________________ .

11. Beta can be computed by using either ............................................. or ____________________________ returns on the individual security and on the market.

Ibbotson uses___________________________ returns in all its computations.

12. For computing beta, the Ibbotson Associates Beta Book uses_______ months for most stocks. If data is not available for this length of time, then data for______ months is used as the minimum acceptable.

13. Betas for publicly traded stocks that reilect the capital stmcture of the companies are re­ ed to as betas.

14. We know the following about Company ABC:
Unlevered beta: 1.25

$75 million
Equity: $25 million

Tax rate: 40%

Compute the levered beta for Company ABC.

15. We know the following about private Company XYZ:

Unlevered beta: 0.50

Levered beta: 1.40

Tax rate: 40%

Total market value of capital: $100 million

What is the market value of the equity for Company XY

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