Using The Capital Asset Pricing Model (CAPM), Discuss And Ca

Using the Capital Asset Pricing Model (CAPM), discuss and calculate the cost of new common stock (Ks)

The Allied Group is planning to expand its operations through significant investments that require new financing sources, including preferred stock, common stock, and bonds. A critical step in this process involves determining the cost of each financing option, particularly the cost of new common stock, which plays a vital role in the company’s weighted average cost of capital (WACC). This paper discusses and calculates the cost of new common stock (Ks) using the Capital Asset Pricing Model (CAPM), examines the dividend yield both currently and in the future, and evaluates the after-tax cost of new debt. Additionally, recommendations are provided based on the analysis, taking into account current economic factors affecting capital raising strategies.

Introduction

Corporate expansion demands meticulous financial planning, especially concerning the sources of capital. The choice between equity and debt impacts the firm’s cost of capital, financial stability, and future growth. The Allied Group’s decision to issue new common stock, bonds, and preferred stock necessitates understanding various costs associated with these options. The CAPM is widely used to estimate the expected return or cost of equity, which guides the company's decision-making process regarding raising capital. This paper applies the CAPM to compute the cost of new common stock and explores dividend yields and after-tax debt costs, aligning these findings with current economic conditions to formulate sound capital-raising recommendations.

Cost of New Common Stock Using CAPM

The CAPM provides a straightforward framework to estimate the expected return on equity, considering the risk-free rate, market risk premium, and the stock’s beta. The formula is expressed as:

Ks = Krf + β (Km - Krf)

Where:

• KrF = risk-free rate = 7%
• β = beta coefficient = 1.3
• Km = market risk premium = 12%

Applying the values:

Ks = 7% + 1.3(12%) = 7% + 15.6% = 22.6%.

This indicates that the cost of new common stock, as per CAPM, is approximately 22.6%. This figure reflects the compensation investors require to hold the company's equity, considering its systematic risk relative to the overall market.

Dividend Yield and Growth Rate Analysis

Dividend yield is a critical component in stock valuation. Currently, the last dividend paid (D0) is $2.25 per share, with the stock price at $29. The dividend growth rate (g) is estimated at 15% for the next three years. The dividend yield today is computed as:

Dividend Yield (Current) = D0 / P0 = $2.25 / $29 ≈ 7.76%

One year from now, the dividend (D1) is expected to grow at the specified rate:

D1 = D0 × (1 + g) = $2.25 × 1.15 = $2.5875

Therefore, the dividend yield one year from now will be:

Dividend Yield (Next Year) = D1 / P1 = $2.5875 / (Yes, stock price is expected to grow, but assuming no change in market price for simplicity, P1 ≈ P0) = $2.5875 / $29 ≈ 8.93%

This indicates a rising dividend yield aligned with the growth of dividends, reflecting increased investor expectations for future payouts.

Cost of Debt Calculation

The company can issue bonds at par value of $1,000 with an 8% annual coupon rate for 30 years. The after-tax cost of debt (Kd) considers the tax shield on interest payments. The before-tax cost (coupon yield) is 8%; thus, the after-tax cost is:

Kd (after-tax) = Kd (pre-tax) × (1 – Tax rate) = 8% × (1 – 0.40) = 8% × 0.60 = 4.8%.

This indicates that, factoring in taxes, the effective cost of debt financing is 4.8%, which is relatively low and advantageous for the company, especially in a tax environment where interest payments are deductible.

Recommendations for Raising Capital

Based on the calculated costs and the current economic outlook, the Allied Group should adopt a balanced approach in its capital-raising efforts. The cost of new common equity, at approximately 22.6%, reflects the firm’s perceived riskiness and market conditions, suggesting that equity financing is relatively expensive. Therefore, the company should consider using a mixture of debt and preferred stock to minimize overall costs while maintaining financial flexibility.

Given the low after-tax cost of debt (4.8%), leveraging debt financing can be advantageous, especially if interest rates remain stable or decline. However, the current economic environment, characterized by fluctuations in interest rates, inflation, and global market uncertainties, warrants cautious use of leverage to avoid excessive financial risk. The firm's positive growth prospects and dividend growth rate of 15% support a strategy that favors equity issuance when market confidence is high, while debt can be utilized strategically for specific projects with predictable cash flows.

Additionally, regional and global economic factors—such as interest rate trends, inflationary pressures, and supply chain disruptions—must influence capital strategies. For example, rising interest rates globally could increase borrowing costs, making debt issuance less attractive. Conversely, a robust stock market may facilitate equity issuance at favorable prices. Moreover, the company's capacity to generate profit and cash flows will ultimately determine its ability to service debt and attract investors.

Conclusion

Effective capital raising for the Allied Group involves a careful assessment of costs associated with equity, debt, and preferred stock. Using CAPM, the cost of new common stock is estimated at 22.6%, reflecting its inherent risk profile. The dividend yield today is approximately 7.76%, increasing as dividends grow at 15%. The after-tax cost of debt stands at 4.8%, offering a relatively inexpensive financing source. Given these insights, a balanced approach—prioritizing debt for its low cost while selectively issuing equity—presents the most prudent strategy in the current economic landscape. The company should continuously monitor economic indicators and market conditions to optimize its capital structure and support sustainable growth.

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