Cost of equity or the rate of return that VISA’s shareholders ‘require’
In order to estimate the cost of equity for the company VISA, I need to obtain an estimate of the company’s ‘beta’ or systematic risk coefficient, on the annual rate of return on a risk-free investment, and on the expected rate of return on the ‘market portfolio’. You can easily find that information by going to the following web site: http://finance.yahoo.com and insert the name VISA. The beta of the company is reported on that web site. Click on the “key statistics” link on the left hand side of the screen to find the beta and other information.
First find out what is the present Yield to Maturity (YTM) on a US Government bond that matures in one year. That rate is the ‘risk-free rate‘.
Next, it is customary to assume that the difference between the expected rate of return on the ‘market portfolio’ and the risk-free rate rate of return is about 7.0%. This is the expression [RM – RF] . So if for example the risk-free rate of interest is, say, 3% per year, than the expected rate of return on the ‘market portfolio’, RM, is 10%. So, multiply the ‘beta’ of VISA Company by 7.0%. That will be the equivalent of VISA’s βj [RM – RF] . Then add to that number the current yield to maturity on a US Government bond [see step (1) above].
The above procedure provides you with an estimate of the rate of return that the shareholders of VISA require on their investment. This rate is called the cost of equity of VISA.
After going through these calculations, PLEASE DESCRIBE IN DETAIL the following information:
1. Show your work you used to obtain the cost of equity for VISA company.
2. Is this cost of equity higher or lower than you expected? The average cost of capital for a firm in the S&P 500 is 10.2 percent. Would you think VISA should have a lower or a higher cost of capital than the average firm?
3. Look up the betas for some of the other companies compared to VISA Company. These are the companies that have a higher or lower discount rate than VISA Company. Using these betas, compute the cost of equity for these firms. How do they compare to VISA Company? Are you surprised that some firms have a higher or lower Cost of equity than VISA Company?
4. How would you go about finding the cost of equity using the dividend growth model or the arbitrage pricing theory for VISA? No calculations is actually needed to do this – just explain how you would go about doing these calculations and explain what kind of additional information you might need.
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