Posted: February 7th, 2016

Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 8.2 percent. Would you think Procter and Gamble should have a lower or a higher cost of capital than the average firm?

I need assistance with the following assignment:

Estimating the cost of equity or the rate of return that Procter and Gamble’s shareholders ‘require’.
The CAPM states the following equilibrium relationship between the (excess) rate of return that shareholders of a particular company “j” require (or actually in some sense ‘deserve’ if they fully diversify their investments) and the (excess) expected rate of return on the market portfolio.

In order to estimate the cost of equity for your company you need to obtain an estimate of the company’s ‘beta’ or systematic risk coefficient, on the annual rate of return on a risk-free investment, and on the expected rate of return on the ‘market portfolio’. You can easily find that information by going to the following web site: http://finance.yahoo.com and insert the name of your company. The beta of the company is reported on that web site.

1. Find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year. That rate is the ‘risk-free rate’.
2. It is customary to assume that the difference between the expected rate of return on the ‘market portfolio’ and the risk-free rate return is about 5.0%. This is the expression [RM – RF]. So if for example the risk-free rate of interest is, say, 1% per year, than the expected rate of return on the ‘market portfolio’, RM, is 6%. Add to that number the current yield to maturity on a U.S. Government bond (see question one).
3. Apply the information you gathered in 1 through 3 to estimate the rate of return that the shareholders of Procter and Gamble require on their investment. This rate is called the cost of equity of your company.
4. Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 8.2 percent. Would you think Procter and Gamble should have a lower or a higher cost of capital than the average firm?
5. Look up the betas for Johnson and Johnson and Kimberly Clarke. Using these betas, compute the cost of equity for these firms. How do they compare to your Procter and Gamble? Are you surprised that some firms have a higher or lower cost of equity than Procter and Gamble?