8.14  Application IBM Step 5:  Estimating the Cost of Equity Capital

As discussed previously in chapters 5 or 6 the most widely used first pass estimate for the cost of equity capital ke is provided from the Capital Asset Pricing Model (CAPM) estimate.  This implies that ke is a function of three major inputs:

Risk free rate (Estimated from US Treasury bonds)

Beta (Measures how much volatility the stock contributes to the market as a whole)

Equity Premium (Excess return expected from stocks over the risk free rate)

 

At the time of this example the 30-year bond rate was 4.19%

To check out estimates of beta for IBM click on Profile in Valuation Tutor:

At the time of this example IBM’s beta, as reported by popular financial sites, was around 0.76.

The equity premium, as discussed in chapters 4 or 5 is currently estimated to be around 5.1-5.5.   The more conservative estimate of 5.5% is used in the current example.

IBM Example:  

The next objective is to estimate the Cost of Equity Capital for IBM, using CAPM.  The following inputs are required for this estimate:

Risk Free Rate = 0.0419

Equity Premium = 0.055

Beta (IBM) = 0.76

Collecting above together ke = rf + βi*(E(RM) – rf) = 0.0419 + 0.76*0.055  = 0.0837