Question

Compute the company Tamawood Limited (TWD) cost of equity using CAPM.

Show the complete calculation process and how you acquire the values to be used in the model. Justify your choice of the risk-free rate, market risk premium and the company beta value. State the cost of equity and comment on the limitation of using that value directly, in relation to the imperfections of the CAPM.

Answer 1

CAPITAL ASSET PRICING MODEL(CAPM) APPROACH :

Capital asset pricing model describes the risk-return trade off for securities. It describes the linear relationship between risk and return for securities.

The risks, to which a security is can be classified into two groups:

1. unsystematic risk
2. systematic risk

Thus ,the cost of equity capital can be calculated under this approach as:

Cost of equity = Risk free rate of return + Premium expected for risk. Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)

calculate the cost of equity capital of Tomatoes limited(TWD),whose risk free rate of return equals to 10%. The firm beta value 1.75 and the return on the market portfolio equals to 15%

solution:

Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)

Cost of equity= 0.10+ 1.75 x (0.15-0.10)

=0.10+1.75 x (0.05)

=0.1875 or 18.75%

LIMITATIONS:​​​​​​​​​​​​​​

a) Estimation of beta with historical data is in realistic ; and

b) market imperfections may lead investors to unsystematic risk.

Despite these short comings, the CAPM is useful in calculating cost of equity, even when the company is suffering losses.