Case Studies in Finance: Estimating the Cost of Capital

Cost of Debt. In Item 8 of Boston Beer’s 2014 10k, the interest rate of the company’s only note is fixed at an annual rate of 4.25%. We take this rate as the cost of debt (Boston Beer Co. Inc.).

Given that the cost of equity is 9.4% and the cost of debt is 12.2%, Star’s cost of capital can be calculated as 9.14% (Appendix B). The company was also considering raising the cost of debt to the industry average of 19%. At this cost of debt, Star Company would have a lower cost of capital of 8.24% (Appendix B) because interest on debt capital is deductible whereas dividend payments on equity capital are not.

Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.

To calculate the cost of debt and equity for this project, we combined the risk-free rate with a risk premium based on the market risk premium and the riskiness of Southwest Airlines.

The debt/equity ratio for Boeing is provided in exhibit 10, 0.525, from where we can infer the weights of both debt and equity.

Based upon the firm’s low target leverage of 5%, low degree of operating leverage, and favorable credit history and financial outlook, the model assumes a cost of debt in line with AAA corporate debt at 7.02%. This estimate seems reasonable and sensitivity analysis shows a 1% decrease in the forecasted share price requires at least a 2.4% increase in the cost of debt.

In utilizing the fundamental data provided by the 2010 Richard Ivey School of Business Foundation article titled Valuing Wal-Mart - 2010, I have made the following conclusions regarding the value of Wal-Mart (WMT) stock as of February 2012.

In order to evaluate the prospective IRRs from the Boeing 7E7, we first try to estimate an appropriate required rate of return for accepting this project. The capital asset pricing model is applied to estimate the cost of equity of the commercial aircraft division:

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

Please refer to Appendix 2 for other considerations for cost of equity calculations. Most firms use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. The components that make up the CAPM include: the risk free rate, the beta of the security, and the expected market return of the stock. These values are all based on forward-looking data. The model dictates that shareholders require a return equal to the return from a risk-free investment plus an equity risk premium for bearing extra risk. Refer to Appendix 1 for a full breakdown of the CAPM formula.

2.) The cost of capital for Boeing would hinged on several factors. Factors such as beta and the debt/equity ratio for Boeing and other companies in the same industry could impact how much Boeing’s cost of capital could be. The marginal tax rate for Boeing was expected to be around 35%. Yields on three-month Treasury bonds were .85% and the yield on 30-year Treasury bonds was 4.56%. On June 16, 2003, Boeing’s stock closed at a price of $36.41. An important factor in figuring Boeing’s cost of capital would be that Boeing was separated into two different businesses. The defense business was more stable due to the declaration of war against Iraq while the commercial business was more volatile due to the events of September 11, 2001. Due to the fact of Boeing being divided into two different

The risk premium is equal to the difference between the risk-free rate and the expected market return. The case study provides two historical equity risk premiums; the geometric and arithmetic mean. The conventional wisdom is that the geometric mean is considered a better estimate for valuation over long periods, while the arithmetic mean a better estimate for valuation over shorter periods. To coincide with the choice of the 20yr yield on U.S. Treasuries, the geometric mean was therefore chosen for this analysis i.e. (Rm-Rf) = 5.9%

The company’s objective is to improve its competitive position in deep-discount brokerage. In order to achieve this objective, the company must grow its customer base, requiring an investment of $100 million to upgrade its technological capabilities as well as an increase of $155 million for its advertisement budget. In order to evaluate the company’s cost of capital, we used the Cost Asset Pricing Model. Since the company went public recently, it would not be an accurate assessment of the risk of

The cost of debt for each division is the government interest rate plus rate premium: lodging: 8.72%+1.1%=9.82%（long-term), contract Services: 6.9%+1.4% =8.3%(short-term) and restaurant: 6.9%+ 1.8%=8.7% (short-term).

We use the Capital Asset Pricing Model (CAPM) to determine the cost of equity. As