What is the cost of equity?

Two weeks ago, we learned about a company’s beta.  Last week, we used the company’s beta when we learned about the capital asset pricing model.  This week, we are going to take things a little further.  In today’s post, we are going to be talking about the cost of equity.

Investopedia states that “a firm’s cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership.”  Traditionally, you would calculate the cost of equity using the dividend capitalization model but what if the firm you are studying does not pay dividends?  We can still use our capital asset pricing model to get the cost of capital.

If the firm that you are studying doesn’t offer a dividend, what else will it do with the money?  It will invest it in a project and use the profits for future dividends or future investment in other projects.  If you put yourself in the shoes of the investor, they could invest in something that pays an immediate dividend and reinvest the dividend in something else.  Alternatively, they could invest in something that doesn’t pay an immediate dividend but pays one down the road.  They are going to want to invest in the option that pays the most, though.  This means that the investor will be happy if the new project pays more than a security of comparable risk would pay.

According to the third edition of Corporate Finance: Core Principles & Applications, “the discount rate of a project should be the expected return on a financial asset of comparable risk.”

The Cost of Equity can be estimated as R_s = R_f + beta*(R_m - R_f)

Where R_f is the risk-free rate, R_m - R_f is the market risk premium, and beta is the stock beta.

This assumes that the stock’s beta is the same as the project’s beta and the firm has no debt.  If the assumptions are not true, the above equation would need to be adjusted.

Let’s look at a quick example.  The risk-free rate of return is typically equal to the United States three-month Treasury bill rate.  As of writing this, it is 0%.  Lets say that the firm has a beta of 1.2 and that the new project has the same risk as the rest of the firm.  Lets also say that the market risk premium equals 7%.

The cost of equity would be:  R_s = 0% + (1.2*7%) = 8.4%

According to the third edition of Corporate Finance: Core Principles & Applications, almost three-fourths of U.S. companies use the CAPM in capital budgeting.


Today, I tried the Segway i2

Joe on a Segway i2

Not too long ago, I saw a groupon become available for Segway tours of Chicago.  I have always been a little curious about the Segway, so I bought the groupon and talked my sister into coming with me down to Chicago for the tour.  Yes, the primary reason for the trip to Chicago was the tour.

We were using the Segway i2.  My first thought, getting on the thing was that it is really hard to steady yourself.  You get more skilled at controlling it, as time goes on but your feet start hurting fast.  You are balancing on it, the entire time you are using it and the constant rocking back and forth works muscles that I just do not have.

The Segway is incredibly nimble.  You can turn insanely tight circles with ease.  The speed is limited to 12 mph.  That said, I am not sure I would want to go much faster than that.  It does not do well with potholes, or cracks in the sidewalk, or bumps.  I am sure, over time you would develop more skill at dealing with obstacles but I was having a lot of trouble.  As soon as you hit something, like a shallow hole in the sidewalk, your balance gets slightly thrown off.  If you are not careful, you are going to fall off.  If you are going fast, the likelihood of this seems much greater.

The big thing I noticed from on-top of the Segway was the attention you get when you are on-top of a Segway.  I would not necessarily call it positive attention either.  One woman, as I rode past, covered her mouth and said “Oh, my God!”  I quickly asked one couple, as I rode past “How do I look on this thing?”  The man replied “Not good, not good” while the woman simply giggled.  It is not exactly like driving around in a Porsche.

So, would I buy one?  Probably not.  It is a $5,000 woman repellent that makes your feet hurt and bucks you off as soon as you come across a crack in the sidewalk.  Would I do the tour again?  Definitely.  The Segway is a fun toy.  I would not want to be zipping around Milwaukee on one but it is kinda fun to play with on occasion.

On a final note, I really like how Groupon sells these opportunities to do weird things that you would never think to do on your own.  I am curious to see what comes next.


How do you show the formulas in Excel?

This is a quick tip.  Lets say you are working on developing an equation within a cell in Excel and you find yourself wanting to refer back to how you set up another cell.  You can click on the other cell and see the equation but how do you show the value of the cell while it is not selected?  Just hit Ctrl + ` on your keyboard.  To toggle it off, just hit the combination again.  It is as easy as that.


What is the capital asset pricing model?

Last week, we talked about what a company’s beta is.  I figured that this week, we would learn about the Capital Asset Pricing Model (CAPM).  According to Investopedia, the CAPM is “a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.”

According to the third edition of Corporate Finance: Core Principles & Applications, the CAPM “implies that the expected return on a security is linearly to its beta.”

The equation: E(R) = R_f + beta * (E(R_m) - R_f)
E(R) is the Expect Return on a Security
R_f is the Risk-free rate
beta is the Beta of the security
E(R_m) is the Expected return on market



In the above graph, the Security Market Line is the depiction of the actual CAPM.  Lets try an example.  If the risk-free rate is 1%, the beta of the security is 1.2, and the expected market return on the market is 11%, then stock should return 13%.


What is a company’s beta?

This is a topic that I recently dealt with within an assignment for class.  Investopedia defines a company’s beta as “a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.”

Illustration of Beta

According to the third edition of Corporate Finance: Core Principles & Applications, when you graph the return on the particular security on theY axis and the return on the market on the X axis, the slope of the line is the Beta.

A beta of 1.21 would mean that for every 1% that the market moves, the company would move 1.21%.  A high beta  would mean that the company is risky.  If the return on the market goes down at all, the return on the security goes down much faster.

Chances are, you will not find a stock with a negative beta but it would mean that the return goes up when the return on the market goes down.

If the beta is zero, it means that the market has no influence at all on the security.

If a security has a beta of one, it means that the return moves with the fund.  An example could be an index fund.

If the security has a beta greater than one, the security is more volatile than the market.

How do you find a company’s beta?  One way is to go to finance.yahoo.com and look under key statistics.  If you prefer to you Google Finance, the same number is listed at the top of the page, next to the stock quote.


Changes on this website

So, as you must have noticed, I have made a few changes to this website.  First, I have moved it to another server, from the same provider.  Second, I have started to use WordPress, as an alternative to the custom-built, hand wrote CMS that I was using previously.  I really did like the idea of using a CMS that I wrote myself but I like using something with features and a community more.  WordPress allows me to do things that I never could have done previously.  I hope to better use this space, moving forward.  Stay tuned for regular, new content.