2. Compute the cost of common equity using the CAPM model. For beta, use the ave

Question

2. Compute the cost of common equity using the CAPM model. For beta, use the average beta of three selected competitors. You may obtain the betas from Yahoo Finance. Assume the risk free rate to be 3% and the market risk premium to be 4%.

a. What is the cost of common equity? (5 pts)

b. Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast this method with the dividend growth model approach. (10 pts)


P.S. Could you provide the sources and how you got the answer too please.

Explanation / Answer

Companies Beta
Northrop Grumman 1.03
Boeing 1.25
Lockheed mArtin 0.59

Average beta 0.95667

a) Risk free rate 3%
Market risk premium 4%
Cost of common equity = Risk free rate + average beta*Market risk premium
Cost of common equity = 3% + 0.95667*4%
Cost of common equity = 6.827%

Beta found from this link: http://uoinvestmentgroup.org/wp-content/uploads/2011/11/LMT-Report.pdf

b)

Advantages

1) It takes into consideration the risk which is reflected by beta to calculate the required return

Disadvantges

1) Some models inputs like beta, risk free rate are difficult to estimate accurately.

Advantages

1) It is relatively simple if dividends are constant forever.

Disadvantages

1) Some companies do not pay dividend whereas others have erratic growth.

CAPM Model

Advantages

1) It takes into consideration the risk which is reflected by beta to calculate the required return

2) It is applicable to all the companies irrespective of dividend paid by them or not.

Disadvantges

1) Some models inputs like beta, risk free rate are difficult to estimate accurately.

2) it relies on past data to predict the futuer data, 3) This assumes that investors has diverisfied portfolios and relevant risk is market risk. Dividend Growth Model

Advantages

1) It is relatively simple if dividends are constant forever.

2) The data for constant growth model are easily available. 3) Floatation cost can be easily adjusted if the cost of new common stock is to be calculated.

Disadvantages

1) Some companies do not pay dividend whereas others have erratic growth.

2) It does not take risk into consideration.

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