The Cost of Equity for Apple, Research Paper Example

For this paper, I have chosen to calculate the cost of equity for Apple. I chose Apple for three main reasons: 1) Apple is emerging as the classic iconic company; it will be interesting to see the financial side of its sales success; 2) Apple, as well as other technology companies, is in a highly unstable sector. I want to understand more how the instability of the technology sector may contribute to the company’s cost of equity.

Calculations

There are three main components that make up a firm’s cost of equity. The first is an estimate of the company’s equity beta, or a measure of the stock’s stability. The second is an estimate of the cost of capital on the general market: this is typically referred to as the “risk-free rate.” The third component is the return on the market portfolio.

Beta Calculation

Apple’s beta, taken from the Google Finance web site, is estimated 1.05. While Apple’s beta taken from the Yahoo Finance web site is .75. In order to incorporate both sites beta estimate, I take the weighted average of the two sites’ beta estimate: .90. Apple’s beta is thus estimated at .90.

Risk- Free Rate

The risk-free rate is an important component of the CAPM. This is because it is a proxy for the cost of capital “without risk.” Although every company has the latent risk of going bankrupt, government debt is considered to be safer. Thus, the interest rate received on a government note of one year in duration will be used as a proxy for the risk-free rate. According to the US Treasury web site, the risk-free rate is .15 or basis points.

Difference between the expected rate of return on market portfolio and risk-free rate

According to information given for this assignment the assumed difference between the expected rate of return on the market portfolio and the risk-free return rate is about 5.0%. Although this difference may have changed due to abnormal market conditions, this assumption will be used for the paper.

Thus the beta of Apple .90*5.0= 4.5= ?_j [R_M – R_F]; 4.5+.15= 4.75%; In theory, based on the above assumptions, the expected cost of equity for Apple is equal to 4.75%.

Is this cost of equity higher or lower than you expected?

I estimated Apple’s cost of equity at roughly 4.75%; this is in the ballpark of what I expected. Although the average cost of capital for a firm in the S&P 500 is 8.2 percent, I would expect Apple to have a notably lower cost of equity for a few reasons:

Apple’s balance sheet has little or no debt, while at the same time having a substantial cash reserves. According to Apple’s most recent regulatory filings, Apple has cash reserves that total $137 billion. Debt or leverage tends to increase the beta of a stock due to the impact of debt on a company’s operational stability that may or may not be reflected in stock price movements. Apple’s beta, however, is below the standard value of 1.0 (noticeably so for Yahoo’s estimate); thus, one would expect less volatility in the stock- one of the key drivers of that lower beta may be Apple’s robust financial position.

Apple has a demanding competitive position that might reinforce the perceived lower beta. Apple, although being chased by Samsung, still holds a commanding competitive position, particularly among technology companies. Compared to other technology companies and the average firm on the S&P 500, I would expect a lower cost of equity.

Here are the betas of other companies that compete with Apple:

Samsung: .81= .81*5.0+.15= 4.20%

Nokia: 1.57 = 1.57*5.0 = 7.85+.15= 8.00%

RIM: 1.65 = 1.65*5.0+.15= 8.40

HTC: 1.39 = 1.39*5.0+.15= 7.10%

Overall, these cost of capital estimations match my expectations. That is, Nokia, RIM, and HTC, firms that directly compete with Apple but that have experienced greater operational and financial instability have a much higher beta (with battered RIM having the highest beta), and thus have a higher cost of equity. Samsung, a company with similar and financial and operational strengths to Apple, actually has a cost of capital that is 55 basis points lower than Apple.

Finding the cost of equity using the dividend growth model or the arbitrage pricing theory for your SLP company

The main analytical problem introduced by the dividend growth model and the arbitrage pricing is that the stock is valued using different methods. For example, the dividend growth method values a stock primarily based on a company’s dividend per share and its expected growth over time. For the cost of capital methodology and in particular the beta methodology, this might give a false impression of greater stability and a higher beta for some companies that issue regular dividends but do not have sound fundamentals. This is a profound difference from the methodology used for the CAPM.

The arbitrage pricing theory introduces similar analytical difficulties. The CAPM’s methodology increases one factor that is related to the non-company and a single beta; this is not the case for arbitrage pricing theory. Arbitrage pricing theory has numerous factors in valuation that are not related to the company, but each requires its own beta.

References:

Google Finance. Apple’s Equity Beta Estimate. Accessed on February 24, 2013.

Yahoo Finance. Yahoo’s Equity Beta Estimate. Accessed on February 24 , 2013.