Determination of the cost of equity capital for Toyota Corporation using

the Capital Asset Pricing Model
Determination of the cost of equity capital for Toyota Corporation
using the Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) provides the framework for the
determination of expected rate of return on a given asset. Additionally,
the model establishes the relationship between the required rate of
return and risk of asset. Implications of the model include the
determination of whether a given security is under- of over-valued. The
relationship between the expected rate of return and risk is established
using the security market line equation (Pandey, 2011). This paper
involves the determination of the cost of equity capital (expected rate
of return) for securities of Toyota Corporation using CAPM.
Toyota Corporation
The security market line equation is as follows
E (Rj) – Rf = ßj [Rm – Rf]
E (Rj) = Rf + ßj [Rm –Rf]
E (Rj) = The cost of equity
Rf = Risk free rate of return = 1 %
ßj = Beta of the security = 0.72 (Source: Yahoo finance, 2013)
RM = Return on market portfolio = 5 %
E (Rj) = 0.01 + 0.72 * [0.05-0.01]
= 0.1288 *100
= 12.88 %
The value of the cost of equity capital (12.88 %) for Toyota Corporation
is higher than the market average value for the S&P 500 (8.2 %). I would
expect the value to be less than the market average because of one main
reason. First, Toyota Corporation is an established firm with a large
market size. This should have increased the certainty of the performance
of the company as a result of large scale production and marketing.
Consequently, this should have raised the confidence of investors in the
Toyota, thus reducing its beta value and the required rate of return.
Other companies used for comparison with Toyota Corporation include Nike
Incorporation, Sony Corporation, and MacDonald Corporation with values
indicated in Table 1.
Table 1: Variables used in the determination of the cost of equity
capital for Nike, Sony, and MacDonald Corporation
Company Risk free interest rate (%) Return on the market portfolio (%)
Beta of the security
Nike 0.40 6.50 0.90
Sony 0.40 9.50 1.60
McDonald 0.40 8.50 0.40
Determination of cost of equity capital
E (Rj) – Rf = ßj [Rm – Rf]
Incorporation
E (R j) = 0.04 + 0.9 * [0.065 – 0.04] *100 = 6.25 %
Sony Corporation
E (R j) = 0.04 + 1.6 * [0.095 – 0.04] * 100 = 12.8 %
MacDonald Corporation
E (R j) = 0.04 + 0.4 [0.085 – 0.04] * 100 = 5.8 %
From the computed values, it is clear that the cost of equity capital
for the three companies is lower than the coat of equity for Toyota
Corporation. However, it is surprising to see that the Sony Corporation
(12.8 %) and Toyota Corporation (12.88 %) have the highest values of
cost of equity capital bearing in mind that the industries in which they
belong are at the highest levels of technological development. It is
normal to expect that investors would have a level of confidence in the
two firms compared to rest because new discoveries and innovations are
becoming availed in motor and information technology industries at a
high rate (Bryant, 2010 and Sturgeon, 2009). This should have reduced
their beta values and the expected rate of return.
Dividend Growth Model
Determination of the cost of equity capital using the Dividend Growth
model requires three variables namely the current dividend, growth of
dividends, and required rate of return. The following formula can be
used to compute the intrinsic value, which represents the cost of equity
capital.
Intrinsic Value = (Current Dividend * (1 + Dividend Growth)) / (Required
Return – Dividend Growth)
The current dividend refers to the dividend payout per share for a full
year, which can be obtained from the financial reports of the company.
Dividend growth is estimated by determining the annual dividend growth
for a period of the last five years (Marquit, 2011). The required return
is an estimated value of the rate of return that an investor would be
expected to request to cover themselves from the risks.
Arbitrage Pricing Theory
Under APT, the asset is assumed to have expected return and unexpected
return. The value of expected return is determined using three main
steps. First, identify key factors that explain the expected return.
These factors include inflation rate, changes in the real rate of
premium, industrial production, change in structure of interest rate,
and change in the real rate of return (Pandey, 2011). Secondly,
determine the risk premium for each of the factors. This value
represents the compensation above the risk free rate of return to
investors for the risk caused by the factor. It is determined using the
past data on forecasted and actual values (Pandey, 2011). Lastly, the
factor beta is determined using the regression
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E(Ri) = Rf + β 1(E(R1) – Rf) + β 2 (E(R2) – Rf) + β 3*(E(R3) – Rf) +
…+ β n*(E(Rn) – Rf)
Where
Rf = Risk free interest rate (i.e. interest on Treasury Bonds)
β i = Sensitivity of the asset to factor
E (Ri) – Rf) = Represents Risk premium
Where i = 1, 2…n
Source: Pandey (2011)
Evaluation of module 3 SLP
Following the completion of Module 3 SLP I, I can now apply CAPM in the
determination of the expected rate of return. The determination of the
cost of equity capital of Toyota Corporation is a clear indication of my
understanding of the CAPM. Additionally, I can now explain the
difference between APT and CAPM. APT was developed to eliminate the
effects of unrealistic assumptions of CAPM. Finally, the module has
equipped me with the knowledge of dividend growth model. I can now apply
it in the determination of implicit cost of equity.
Reference
Bryant, E. (2010). From data to knowledge to action: Enabling 21 st
century discovery in science and engineering. Information Technology,
13, 2-4.
Marquit, M. (2011, May 30). The dividend growth model. Retrieved
February 20, 2013, from
http://www.dividendstocksonline.com/2011/05/the-dividend-growth-model/
Pandey, M. (2011). Financial Management. New Delhi: Vikas Publishing
House PVT.
Sturgeon, J. (2009). Globalization of the automotive industry.
International Journal of Technological Learning, 2 (1), 7-11.
Yahoo Finance (2013, February 21). Toyota Motor Corporation (TM).
Retrieved, February 21, 2013, from http://finance.yahoo.com/q?s=TM
THE COST OF EQUITY
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