North West Company Case

Barb Williams and Rick Thomas, while attending an executive education course at a well-known business school, came across a case which involved calculating the cost of capital for Telus Corporation (Telus). Basic data such as the Balance Sheet, Income Statement, Data on Telus’ Common Stock, Market Index, and the Average Annual Returns in North American Capital Markets were provided. In order to calculate Telus’ cost of capital we need to calculate the company’s Cost of Equity, Cost of Debt, and Tax Rate along with their weighted cost and then apply these to the Weighted

What are some alternative ways to obtain a market risk premium for use in a CAPM cost-of-equity calculation? Discuss both the possibility of obtaining estimates from outside organizations and also ways which Ace could calculate a market risk premium itself.

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.

A few weeks earlier, John M. Case, board chairman, president, and sole owner of the

Using CAPM to provide the calculation for the equity, this presents both positive and negative effects.

The next step was to determine the cost of debt and cost of equity. Case assumptions made by Liedtke of a 40% corporate tax rate, 6% estimated cost of debt, and 20% leverage were used in calculating the cost of debt. The cost of debt was determined to be 3.6% (= Debt*(1-Tax Rate).

Weights of Debt and equity are 8.3 and 91.7%. Now, plugging all the values in, we can derive company’s Weighted Average Cost of Capital.

Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,

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.

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.

3) What is the weighted average cost of capital and why is it important to estimate it? Is the

of outstanding shares) + (short-term debt + long-term debt + capitalized leases + preferred stock - cash on hand)

3. Calculate the cost of equity capital using the CAPM, assuming a market risk premium of 5%.

Figure 9 (page 27 – 29) shows the security market line input data and graph. The security market line equation is used on page 27 to calculate the required rate of return on each investment alternative. Each investment’s expected return is compared to the required return calculated by the SML. Based on whether or not the expected return is higher or lower than the required return will determine if the investment is overvalued, fairly valued, or undervalued. For example, page 27 shows that Gold is overvalued and Food is undervalued.

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