6.10  Example:  IBM’s Cost of Equity Capital from CAPM

Valuation Tutor’s information system provides quick access to information to apply the CAPM:

Under “Bonds,” you can find rates on US Treasuries.  You may want to pick a long term interest rate, since we are going to be discounting the dividends for a long time (in fact, forever!).   At the time of this writing, the yield on the 30 year Treasury bond was 4.18%.

To get an estimate of beta, select one of the sources under “Profile.”  At the time of this example, IBM’s beta was 0.73.

Now we need the equity premium.  Many sources report an equity premium, and the estimates can vary quite a bit.  Under “Papers and Reports,” we have a link to a paper by Professors Pablo Fernandez and Javier Del Campo Baonza at the University of Navarra, who did an extensive survey of estimates of the equity premium. The consensus estimates are in the 5.1% to 5.3%, and most estimates fell between 5.1% and 5.5%. We will use 5.1% in our examples.

Our estimated inputs provide you with an estimate of k_e for IBM:

Note: the CAPM only provides the discount rate for cash flows (like dividends) that accrue to shareholders.  It does not provide a discount rate for the cash flows of the firm as a whole (so payments that accrue to both shareholders and bond holders).  For a firm as a whole, the discount rate is usually specified as a weighted average of k_e and the yield on the debt of the firm, k_d.  The WACC, or weighted average cost of capital, is defined by:

Here, τ_c is the corporate tax rate.  The equation works with the after tax cost of debt because interest expense is tax deductible while dividend payments are not.