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Proper Use of Betas

This chapter tests basic concepts about the size premium and about Ibbotson Associates3 methodology for computing it. The topic is explored furtlier in Chapter 1.3, "Using ibbotson Associates Cost of Capital Data".

1. The size premium as calculated by Ibbotson Associates is supposed to be used in which of the following models to estimate the cost of equity capital?

a. CAPM only.

b. The build-up model only.

c. "Both CAPM and the build-up model.

d. None of (lie above.

2. The size premium as calculated by Ibbotson Associates equals:

a. The product of beta and the arithmetic mean return minus the CAPM-estimated return in excess of the riskiess rate.

b. The product of beta and Ihe arithmetic mean return minus Ihe realized return in excess of the riskiess rate.

c. The realized return minus the C A PM-esfimated return.

d. The realized return in excess of the riskiess rate minus (lie CAPM-estimated return in excess of the riskiess rate.

3. CAPM makes no distinction between the general equity risk premium for the market as a whole and the equity risk premium for a specific security.

4. The Ibbotson Associates studies and tlie Standard & Poor's Corporate Value Consulting (S&P CVC) studies on the size effect cover (he same size categories over the same period of time and thus yield similar results.

5. The size effect refers to tlie general idea that smaller size is associated with risk and, therefore, with........................ cost of capital

6. The smallest decile in Ihe ibbotson Associates analysis of the size effect is the decile.

The following are known about the 10th decile of a market:

Realized return in excess of the riskless rate: 16%

CAPM-estimated return in excess of the riskless rate: 11 %

1.5

Risk-free rate: 6%

7. Compute Ihe size premium according to the methodology employed by Ibbotson Associat

8. Compute the general equity risk premium for the market as a whole.

9. Compute the equity risk premium for the 10th decile, according to CAPM.

0. Compute the CAPM-estimated return for the 10th decile.

Given the risk-free rate of 6% and tlie general equity risk premium for tlie market as com­puted in question 9, what should beta for tlie 10th decile be for CAPM to be accurate?

The discounted cash flow (DCF) method of estimating the cost of capital is so named be­cause it rearranges the DCF formula so the present value is known and tlie cost of capital is the unknowrn. It uses the current market prices of stocks along with dividends and analysts' growth estimates to get an implied cost of capital.

MULTIPLE CHOICE QUESTIONS

1. Which of tlie following is a correct statement about the DCF method of estimating the cost of capital?

a. ft can only be applied directly to private companies.

b. It can only be applied directly to public companies,

c. It can be applied directly to either public or private companies.

d. It cannot be applied directly to either public or private companies.

2. The cost of capital estimates by the DCF method:

a. Represent the company's overall cost, of capital (WACO).

b. Represent the equity risk premium.

c. Represent the entire cost of equity.

d. Represent the risk-free rate and the equity risk premium but. not the size effect.

3. Which of the following is NOT an assumption of the DCF method of estimating tlie cost of capital?

a. The company's current stock price embodies the market's expectation of the rate of re­ turn that will be realized by investing in that stock.

b. The company's current stock price is actually tlie sum of tlie present values of (lie ex­ pected returns to the investors (dividends and stock price change).

The company's current stock price is equal to its expected future returns discounted to a present value at a discount rate that represents trie cost of equity capi tal for mat company.

I Rational investors seek to hold efficient portfolios, that is, portfolios that are diversified.

4. A weakness of the DCF method of estimating the cost of capital is that most published estimates come from ''buy-side" stock analysts, which may be biased.

5. Most multistage DCF models for estimating the cost of capital are more reliable than single-stage models.

6. What are the two main types of models used to implement the DCF method as it is applied to estimating cost of capital?

7. What is a published source of industry average costs of equity capital that are based on the DCF model?

8. Given the following about Company ABC:

Dividend latest 12 months: SI,00 per year

Analysts' growth estimate: 5%

Stock price: S10.00 per share

Estimate ABC's cost of equity capital using the single-stage DCF model.

9. You have been asked to estimate the cost of equi ty capital for public Company X YZ. In the course of your research, you observe that analysts following Company XYZ estimate that it will grow at 7,0% over the next five years. Furthermore, the growth rate estimate for Com­pany XYZ's industry is expected to approximate 1.0.7% over the next 10 years, which you can use for the second stage (years 6 through 10) of the DCF method. Provided that long-term macroeconomic growth should approximate 6,5%, XYZ's current stock price of $61.70, and an annual dividend of $1.60 (assuming a constant dividend payout ratio), cal­culate XY^Z's cost of equity capital using a multistage DCF model.

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