question archive You need to estimate the equity cost of capital for XYZ Corp
You need to estimate the equity cost of capital for XYZ Corp
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You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past returns:
year risk-free return market return XYZ return
2007 3% 6% 10%
2008 1% -37% -45%
a. What was XYZ’s average historical return?
b. Compute the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.
c. Estimate XYZ’s historical alpha.
d. Suppose the current risk-free rate is 2%, and you expect the market’s return to be 9%. Use the CAPM to estimate an expected return for XYZ Corp.’s stock.
e. Would you base your estimate of XYZ’s equity cost of capital on your answer in part (a) or in part (d)? How does your answer to part (c) affect your estimate? Explain.
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Ans :
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Requirement a |
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XYZ Corp. |
2007 |
2008 |
Details |
Ans : |
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Actual Return |
10% |
-45% |
(10-45)/2=-35/2 |
-17.5% |
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Requirement b |
Excess Return = Actual Return – Risk free Return |
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Market Return |
XYZ Corp. |
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2007 |
2008 |
2007 |
2008 |
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Actual Return |
6% |
-37% |
10% |
-45% |
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Less: Risk free Return |
3% |
1% |
3% |
1% |
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Excess Return |
3% |
-38% |
7% |
-46% |
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Beta = Change in XYZ Excess Return/ Change in Market Excess Return = [(7-(-46)] / [ (3-(-38)] = [7+46] /[ 3+38] = 53 /41 = 1.2926 |
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Requirement c |
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According to the result as obtained in (B) above |
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Alpha (Intercept) = |
[ E (Rs) – Rf ] - Beta [ E (Rm) – Rf ] = |
[ (7 – 46) / 2] – 1.2926 [( 3 -38)/2] |
-19.5 -1.2926 (-17.5) =3.1205% |
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Requirement c |
Using CAPM = Rf + ( Rm – Rf ) Beta = 2% + ( 9-2) 1.2926 = 11.0482% |
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