Cost of Capital Project

The goal of the project is to find the cost of capital of a company and compare your estimates of the cost of capital with ROE and ROA of the company.

Choose one of your favorite companies and collect relevant information from SEC website (www.sec.gov) for financial statements, or any other financial websites such as Yahoo Finance, Bloomberg, etc. Those financial websites often provide stock returns and analyst forecasts.

When choosing a company, do not choose a firm that has less than five years public record, or has no dividends.

To estimate WACC, the weighted average cost of capital, we will make the following simplifying assumptions:

1. For the cost of debt, try to use the yield to maturity of a 30-year (or close to 30 years) bond of the company (http://finance.yahoo.com/bonds), or an outstanding bond that has at least ten years to mature if the company does not have a 30-year bond outstanding.

i. If the company only has one bond outstanding with at least ten years to mature, use that bond.

ii.

If the company has a few outstanding long-term bonds, use the average of the yields to maturity, weighted by the years to maturity.

iii. If the companys bonds are less than ten years to mature, try to find the yield to maturity for the similarly rated bonds from other companies.

iv. If the company does not have any long-term bonds, just assume that the company does not have debt financing.

2. For the cost of equity, use both CAPM and Dividend Discount Model (DDM).

i. You should compare the two estimates and judge the merit of each one. Use the average of the two estimates as the cost of equity.

ii. The spreadsheet attached has an actual example showing how beta is estimated. Use at least 10 years of monthly returns to estimate beta.

iii. Compare your estimate of beta with the estimates obtained from the financial websites and judge whether your estimate of beta is reasonable.

iv. The spreadsheet also has an example of using historical DPS (dividend per share) to estimate the dividend growth rate, or using analyst forecasts to estimate the growth rate. All the information should be available from Yahoo Finance, MSN Money, or other financial websites.

v.

When using CAPM to estimate the cost of equity, we need to use the current market risk premium, not the historical number. However, you could use the historical market risk premium to approximate the current market risk premium. In order to calculate the historical market risk premium, please go to http://research.stlouisfed.org/fred2/categories/115 to download the appropriate risk-free rate. Note that the risk-free rate is given as an annual rate. You are not restricted to use historical estimates. Other ways of estimating the market risk premium such as from a survey data is fine as long as you clearly state how you obtain the estimate.

3. For the cost of preferred stocks, you only need to calculate it if the company has preferred stocks outstanding.

4. Since we do not know the target capital structure, we will use the current capital structure from the current market value.

5. Judge whether your estimate of cost of capital is reasonable. One way to do that is to compare with the estimates obtained from other sources.

6.

Compare the estimated cost of capital with ROE and ROA of the company. What can you learn about the performance and profitability of the company?

Note: