Cost of equity for Apple Incorporation
Basically, the cost of equity for Apple Inc. is given by the formula: Rj = RF + βj [RM – RF]. However, the expected market portfolio rate of return (Rm) is 10% and the risk-free return rate (Rf) is 3%. Therefore, the difference amid Rm and Rf which is given by [RM – RF] = [10 -3] = 7%. Since Apple Inc. beta (βj) is equal to 0.94, then βj [RM – RF] = 0.94 x 0.07 =6.58%. This implies that, from the formula Rj = RF + βj [RM – RF], the cost of equity (COE) for Apple Inc. = 3% + 6.58% = 9.58%.
The expected cost of equity and cost of capital
From the computed cost of equity, it materializes that the value is higher than expected. This follows the fact that the obtained cost of equity is the compulsory rate of return that the stakeholders demand from Apple Inc. while they assume any risks that are associated with it. If the risk factor could have been incorporated in the computed COE, then it could have been significantly lower than anticipated. Conversely, the cost of capital in any firm plays a critical role pertaining to capital budgeting decisions. As the minimum return rate that firms must earn on the investments, the cost of capital persists to be in constant consonance with the overall objective of the firms, that is, wealth maximization (Clark, 2000). Because an average firm in S&P 500 has a 10.2% average cost of capital, Apple Inc. should have a relatively higher cost of capital. This will enable this firm to increase or maintain its total market share value.
Competitive firms’ betas and their respective cost of equity
Taking into consideration two of Apple Inc. market competitors namely Hewlett-Packard and International Business Machines Corporation (IBM), it is apparent that the betas (βj) for these market competitors are 1.41 and 0.62 respectively. But given that the formula for calculating the COE is Rj = RF + βj [RM – RF], whereby RF is assumed to be 3% while RM is 10%, then the COE for these two firms could be computed as follows:
- The COE for Hewlett-Packard = 3% + 1.41 [10% -3%] = 12.87%
- The COE for IBM = 3% + 0.62 [10% – 3%] = 7.34%.
From the above-computed COE figures, it emanates that when compared to Apple Inc. COE value, IBM has a lower rate of return which its shareholders necessitate on their investments. However, HP has a comparatively higher COE figure than both IBM and Apple Inc. Despite the higher COE reported by Hewlett-Packard, both Apple Inc and IBM have larger market shares but still, IBM has dominated the industry’s global market share. Therefore, it is indeed a great surprise that a firm like Hewlett-Packard has a higher cost of equity when compared to Apple Inc. while my SLP Company has a considerably higher CEO than IBM.
How to use dividend growth model to compute the cost of equity
The cost of equity entails the requisite rate of return on the invested equity. To find the cost of equity via the dividend growth model, additional information such as the current stock price, dividend growth rate as well as next year’s annual dividend is required (Campbell, 1995). The COE using the dividend growth model is given by the formula: Cost of equity = [Dividend growth rate + (Next year’s annual dividend Ă· current stock price)]. To illustrate this, assume that Apple Inc. has the following financial information:
Dividend growth rate = 3%, next year’s dividend = $2 and current stock price = $ 15.
Through the dividend growth model, therefore, the cost of capital or equity for Apple Inc. is found via computing [3% + ($2 Ă· $15)] = 16.3%. Despite the fact that the dividend growth model appears to be very simple and straightforward, it cannot be used to compute the cost of equity for firms that do not pay dividends. Nonetheless, this model assumes that a constant rate in dividends is eminent over time.
Using arbitrage pricing theory to compute the cost of equity for Apple Incorporation
This theory is founded on the assumption that just limited determined factors persist in the economy. Such factors include unanticipated changes in the gross national product and unexpected inflation. These factors are alleged to affect the prices of risky assets. Regardless of this additional information, the arbitrage pricing model asserts that the ensuing risks are multidimensional (Boehme, n.d). Thus, to find the cost of equity via the arbitrage pricing model, the following formula must be applied: K = [r.sub.f] + [b.sub.1][RP.sub.1] + [b.sub2][RP.sub.2]+…+ [b.sub.k][RP.sub.k]. Whereby, the rate of return risk-free rate is given by [r.sub.f], the stock risk is given [b.sub.i] which is with reference to the risk factor i while the price per a single unit of i risk factor is represented by [RP.sub.i]. This model is similar to CAPM but only differs on the market risk portfolio (Investopedia.com, 2011).
Lessons learnt in the Module 3 SLP and the module assessment
Generally, module 3 SLP has enabled me to learn about various concepts including portfolio diversification, capital asset pricing model (CAPM), risks and returns as well as the computation of the cost of equity and capital. Furthermore, the module has enhanced my understanding with regard to the dividend growth model, arbitrage pricing theory and capital asset pricing as they are applicable in different market and financial scenarios. From the start of module 3 SLP, the tutor has been cordial, vocal, responsive and very categorical in each and every illustration put forth. This facilitated my understanding and mastering of the various concepts that were taught in this module.
References
Boehme, R. (n.d.). Chapter 11: Arbitrage pricing theory (APT). Web.
Campbell, H. (1995). The CAPM – WWW.Finance. Web.
Clark, T. (2000). Earnings growth and stock returns. Web.
Investopedia.com (2011). Financial concepts: Capital asset pricing model (CAPM). Web.