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Live Case Study #1 – Estimating Risk and Cost of Equity

FIN:3300:0EXW – Corporate Finance

1. Estimate the Equity Beta.

Estimate the firm’s equity beta using 5 years of monthly data. Include the Excel regression output for your beta estimate. Note that “beta” is the coefficient estimate on the X variable on your regression output.

I download the AMZN’s historical records of 5 years of monthly data, and I compared its monthly adjusted closed price with S&P 500 with “REGRESSION” function in excel. Then, the Equity Beta is represented by the coefficients' X variable numbers, so beta is 1.23 (Yahoo!, 2022).

2. Get the Risk-Free Rate.

Find the current yield on the 10-year U.S. Treasury bond to use as the risk-free rate.

You may use the most recent yield on the 10-year Treasury constant maturity security (nominal) from the website below. Note that the Treasury yields are given in percentages, you need to divide them by 100)

https://www.federalreserve.gov/releases/h15/

For the purpose of this assignment, I have chosen the 10-Year Treasury constant

maturities of US Government securities which is 3.2%.

Rf = 3.2% (Board of governors of the Federal Reserve System, 2022)

3. Get an estimate of the Market Risk Premium from the web site below (use implied equity premium): (Use the most recent “Implied ERP”, trailing 12 month, with adjusted payout)

http://pages.stern.nyu.edu/~adamodar/

Implied Equity Risk Premium on July 1, 2022= 5.69% (Damodaran online: Home page for Aswath Damodaran, 2022).

4. Estimate the Cost of Equity Using CAPM.

a. Compute the firm’s cost of equity using the CAPM equation. (use the values from questions 1-3 as your CAPM inputs)

By using CAPM equation: R = Rf + β * ( Rm – Rf ) & Equity Risk Premium = Rm- Rf

Equity Risk Premium = 5.69%

Rf = 3.2%

Beta = 1.23

So, R = 10.20%

b. What is the company’s average annual return in the last 5 years?

i. You may first calculate the geometric average of the monthly returns you calculated in part 1 using Excel’s “GEOMEAN” function, and then calculate the annualized return.

ii. Annual return = (1+monthly return)^12 -1

iii. See the link below for Excel’s GEOMEAN function:

https://www.youtube.com/watch?v=nAaQLJghH1k

I used “GEOMEAN” function to find out that:

G.M of AMZN YEAR 1 = -5.33%

G.M of AMZN YEAR 2 = 1.05%

G.M of AMZN YEAR 3 = -5.38%

G.M of AMZN YEAR 4 = -0.05%

G.M of AMZN YEAR 5 = 3.91%

Annual return = -13.79%

c. How does the stock performance (average annual return in the last 5 years) compare to the risk-adjusted hurdle rate (i.e. cost of equity)? Is the stock over or underpriced? (You may use the security market line to see if the security is mispriced)

We should compare the two sorts of annual returns I've calculated earlier in this part using two distinct approaches. One approach uses the risk-adjusted CAPM calculation, and the other uses the geometric means of individual years, which are then added together to create an average return for the entire five-year period.

The risk-adjusted rate I estimated in the previous section is 10.2% compared to our average yearly return over the past five years, which is -13.79%. It is clear from this research that the security is undervalued. In addition, we can observe that AMZN is listed at the top of the SML chart. The position on the chart shows that the security offers a higher return against its inherent risk, hence it is thought to be undervalued.