First, compute the de-meaned cash flows: Year 1999 2000 2001 2002 2003 2004 Average Variance S&P 500
Question:
First, compute the de-meaned cash flows:
Year 1999 2000 2001 2002 2003 2004 Average Variance S&P 500 +21.4% −5.7% −12.8% −21.9% +26.4% +9.0% +2.7% 373.4%%∗
Cash Flows +$2,864 +$1,666 −$1,040 +$52 +$1,478 −$962 +$676 De-meaned S&P 500 +18.7% −8.4% −15.5% −24.6% +23.7% +6.3% 0%
De-meaned Cash Flows +$2,188 +$990 −$1,716 +$624 +$802 −$1,638 $0 Cross-Product $408.36 −$83.46 $266.60 $153.79 $189.73 −$102.67 $166.47∗
The asterisk reminds you that I divided both the average cross-product and the variance by 5 rather than 6 to reflect the fact that this is a sample and not the population. The cash flow beta is about
$166.47/373.4%% ≈ $4,458.19.We now have the inputs to use our formula:
This suggests a cost of capital of about E(C1 year)/P0 − 1 ≈ $676/$484 − 1 ≈ 40%. It turns out that this firm was Sony. This cost-of-capital estimate seems far too high. This is probably because the cash flow beta of Sony was way too high in relation to the ordinary CAPM market beta of Sony. Our CEV calculations did not do well in assessing value, probably because Sony’s cash flows were far more volatile than its value.
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