ou want to calculate a reasonable cost of equity for PFZE Inc. To do so, you have decided to rely on the cost of equity equation E[R] = Risk Free Rate + Beta * Market Risk Premium to estimate the cost of equity. For the debt part you use the yield to maturity of the debt as the cost of debt. Below is the relevant information.

• PFZE Inc. has two major sources of financingcommon stock and long-term debt. It currently has 1,000,000 shares of stock outstanding, which are trading at a price of $10 per share. Its debt carries a current market value of $5,000,000. The debt was issued a year ago having at that point in time a 20-year maturity and an annual coupon, paid annually, of 5.0%.

• The condensed current balance sheet (at book value) for PFZE Inc. is provided below (in thousands). The long-term debt was recorded on the balance sheet at its face value at the date it was issued.

Assets

Cash and short-term assets $1,000 Inventory $200 Receivables $300 Property plant and equipment (net) $6,900

Total assets $8,400

Liability and Equity

Accounts payable Long-term debt (Face value) Shareholders equity

Total liabilities and equity

$400 $4,000 $4,000

$8,400

• You have decided to use the US Treasury Bills as your benchmark for the risk free rate. These bills earned a return of 2.5% for each of the past 10 years and currently carry a yield-to-maturity of 3.0%.

• Youhavecompiledmarketratesofreturnandrisk-freeratesofreturn(i.e.,one-monthT-bills)overthelasteightdecades:

Mean

Risk Premium (vs. T-Bills)

Real Return (vs. Inflation) 12.3% 8.9% 2.9% 2.5% 0.4%

Small Companies Stock Market (S&P 500) Index Long-Term Corporate Bonds Long-Term Government Bonds US Treasury Bills

Inflation

15.3% 11.9% 11.9% 8.5% 6.2% 2.9% 5.9% 2.5%

3.4% - 3.0% -

Finally, you have regressed the firms return on the market return using the last 60 months of available data, that is you used 720 observations, and obtained the following results (The R-squared from this regression is 10%):

Variable Intercept Slope

Coefficient Std. Dev. 0.08 5.5% 2.12 12.0%

a. What is your estimate of the risk-free rate of return? Explain.

b. What is your estimate of the market risk premium if you were to use the Treasury Bills as the reference for calculating the risk premium? Explain.

c. What is your estimate of the firms beta? d. Calculate an approximate 95% confidence interval for your beta estimate. How precise is your estimated beta? e. What is your estimate for the cost of equity? Cost of debt? f. If the tax rate is 20.0%, what is the weighted cost of capital?