Cost of Equity Facebook A-Level Outline Answer

Excerpt from A-Level Outline Answer :

equity at Facebook is to use the capital asset pricing model. The formula for CAPM is as follow:

Rj = RF + ?j [RM - RF]

The first step to determining the cost of equity is to gather the different variables go into CAPM. The risk free rate is the first such variable. The risk free rate reflects the rate of return that an investor can earn on an investment that has no risk The only investments that are deemed to have no risk are Treasury securities. This is because the U.S. Treasury prints money, so there is zero risk that these will not be repaid. There is risk that the payment will not have the same real value, but it will have the same nominal value as expected.

According to the U.S. Treasury webpage, a one-year Treasury bond carries with it a rate of 0.13%. This is the risk free rate to be used in the capital asset pricing model calculation.

The next step is to calculate the market risk premium. This is assumed to be 5%. This means that the component of CAPM that is [RM - RF] is 5%. The expression RM must be 6%, given this.

The remaining variable is the beta, which is the expression of the correlation between the performance of the company and performance of the general market. The beta essentially is the firm-specific risk of the company while the other components of CAPM are the risk-free rate and the market risk premium. Facebook began trading in May, 2012. There is a beta listed on Yahoo Finance of 1.77 for Facebook, so this can be used to calculate the cost of equity for the company using CAPM.

R (fb) = 0.13 + (1.77)(5) = .13 + 8.85 = 8.98%

This figure is fairly high, but reflects two key facts about Facebook. The first is that the company has had a somewhat volatile history with its stock price thus far. The second is that the company's cash flows are still in a state of flux. Facebook's high profile contributes to this situation, and the company therefore has a high cost of equity.

The cost of equity is about what I might have expected. I expected a high level of volatility in Facebook's stock. There is one thing about comparing it to the S&P 500 return. The expected return on the S&P 500 is not 8.2% - this is not the average cost of capital. The average cost of capital for the market is as follows:

0.13 + 5 = 5.13%, because the beta on the S&P…

Sources Used in Document:

Sources

Campbell, H. (1995). The CAPM - WWWFinance. Retrieved May 2012 from http://www.duke.edu/~charvey/Classes/ba350/riskman/riskman.htm

Investopedia.com (2012). Financial concepts: capital asset pricing model (CAPM). Retrieved May 2012 from http://www.investopedia.com/university/concepts/concepts8.asp

Yahoo! Finance. Retrieved November 18, 2013 from http://finance.yahoo.com/

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