Sample Essay – cost of equity
Cost of Equity = Expected Rate of Return on Earnings = Rj
According to the CAPM model:
Rj = RF + (RM – RF)βj
- The beta of Johnson & Johnson (symbol JNJ) as reported is 0.32 (JNJ: Key Statistics for Johnson and Johns DC)
A beta of 0.32 means that JNJ stock is much less risky as compared to an average stock on the market.
As given in the question, (RM – RF) = 7%
YTM on a US Government bond that with two years maturity = 1.62 (Bonds Center)
1. Now, the cost of equity of JNJ stock:
Rj = RF + (RM – RF)βj = 1.62% + (7%)(0.32) = 1.62 + 2.24% = 3.86%
- Asset Beta of JNJ, βA
βE = βA [1 + (1-T) (D* / E*)]
βA = βE / [1 + (1-T) (D* / E*)]
= 0.32 / [1 + (1 – 0.34) (9.54B/43.36B)] Note: Check the D* and E* values you have submitted in SL2 and replace them in the equation if they are different from the ones reported here
= 0.32 / [1+ (0.76) (0.22)]
βA = 0.28
Asset beta shows the business risk of an organization; put another way, it is the beta of an organization without the effect of financial leverage. That is why asset beta is also referred to as the unlevered beta. “This number provides a measure of how much systematic risk a firm’s equity has when compared to the market. Unlevering the beta removes any beneficial effects gained by adding debt to the firm’s capital structure. Comparing companies’ unlevered betas give an investor a better idea of how much risk they will be taking on when purchasing a firms’ stock” (Unlevered Beta). This is why when a firm changes its capital structure, the risk and expected returns of its debt and equity change, but the asset beta, and thus company cost of capital do not change. Note that, cost of capital is the weighted average return that investors expect of a firm’s debt and equity. And since, asset beta is the weighted average of the betas of debt and equity; hence the cost of capital is related to a firm’s asset beta and not its equity beta.
JNJ has a low asset beta because its business is not cyclical.
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