Question

You need to estimate the equity cost of capital for XYZ Corp. You have the following data available regarding past​ returns:

Risk-free Return Market Return XYZ Return
2011 2% 6% 9%
2012 1% -33% -46%.
a. What was​ XYZ's average historical​ return?
b. Compute the​ market's and​ XYZ's excess returns for each year. Estimate​ XYZ's beta.
c. Estimate​ XYZ's historical alpha.
d. Suppose the current​ risk-free rate is 4%​, and you expect the​ market's return to be 10%.

Answer 1

To estimate the equity cost of capital for XYZ Corp., you need to calculate the average historical return, compute the market and XYZ's excess returns for each year, estimate XYZ's beta, estimate XYZ's historical alpha, and use the CAPM formula to estimate the equity cost of capital.

Step-by-step explanation:

a. To calculate XYZ Corp's average historical return, we sum the returns for each year and divide by the number of years.

b. To calculate the market's excess return, we subtract the risk-free return from the market return for each year. To calculate XYZ Corp's excess return, we subtract the risk-free return from XYZ Corp's return for each year. XYZ Corp's beta can be estimated by dividing XYZ Corp's excess return by the market's excess return.

c. To estimate XYZ Corp's historical alpha, we subtract XYZ Corp's beta multiplied by the market excess return for each year from XYZ Corp's excess return for each year.

d. To estimate the equity cost of capital for XYZ Corp, we can use the CAPM formula:

Equity Cost of Capital = Risk-Free Rate + (Beta x (Market Return - Risk-Free Rate))

Given that the current risk-free rate is 4% and the expected market return is 10%, we can substitute these values into the formula to estimate the equity cost of capital for XYZ Corp.