Explain the three types of risk and beta.
In this assignment, you will recalculate the value of the company’s stock based on your company’s specific required rate of return. To do this, you will calculate the required rate of return for your chosen publicly traded company using the capital asset pricing model (CAPM).
Last week, you determined a preliminary estimate of the company’s stock price using the constant growth formula. To simplify the calculation, you were required to use general market required rates of return, based on size. However, this is an assumption that does not account for the specific risk of an investment in a specific company. This week, you will calculate the required rate of return for your chosen publicly traded company using the CAPM. The CAPM is a more precise tool to estimate a firm’s required rate of return. This tool is “tremendously valuable because required returns are used as the discount rates in the valuation formulas when doing time value of money problems and security valuation” (Hickman et al., 2013, Section 9.3, para. 1). You will then use this CAPM required rate of return to revise your stock price value based on the constant growth formula. This will allow you to determine your final recommendation of buy, hold, or sell.
Prior to beginning work on this assignment,
- Complete both of the Week 4 learning activities
- Review Chapters 7 and 9 of Essentials of finance.
- Review the Week 5 – Final Project.
- Review the Week 4 Model Assignment (Links to an external site.).
- Watch the following video:
In your paper, address the following five parts in a Word document:
Part 1: (two paragraphs)
- Explain the three types of risk and beta, and how these concepts relate to a company’s required rate of return.
Part 2: (two paragraphs)
- Find your company’s beta from a credible source.
- You can get this information from the Mergent database or by looking it up on a financial website like Yahoo! Finance (Links to an external site.).
- Compare your company’s beta to the market beta of 1.0.
- Calculate the company-specific required rate of return using the CAPM formula.
- Show all calculations.
- Use the beta you determined for your chosen company
- Use a risk-free rate of 2.0%.
- For the market risk premium, use the following assumptions:
- For a large capitalization company (greater than $10.0 billion in market capitalization) use 6.0% as the market risk premium.
- For a mid-cap company (between $2.0 billion and $10.0 billion in market capitalization) use 8.0% as the market risk premium.
- For a small-cap company (less than $2.0 billion in market capitalization) use 11.0% as the market risk premium.
- Compare the company-specific required rate of return you calculated to the required return based on size you used in Section 3: Dividend Analysis and Preliminary Valuation in Week 3 for the constant growth formula.
- Determine whether the company-specific required rate of return higher or lower than the rate of return based on size that you used in Section 3 in Week 3 for the constant growth formula?
- Explain the difference in required rate of returns.
Part 3: (two to four paragraphs)
- Recalculate both estimates (the low-end and the high-end) of the stock price using the constant growth formula.
- Use the company’s specific required rate of return you determined using the CAPM.
- Review your selected high-end and low-end growth rates from Week 3.
- If either growth rate is higher than the new CAPM discount rate, you must reduce your selected growth rate(s).
- Your growth rates cannot be higher than the discount rate, because the calculations will result in a negative stock price, which is not meaningful.
- Include a short, written explanation to explain the revised growth rates.
- Show your revised high-end and low-end stock price calculations
- Compare each of the two recalculated stock prices to the current stock price per share of the company.
- State whether each recalculated stock price (low-end and high-end) is above or below the current market price.
- State whether each recalculated stock price (low-end and high-end) indicates if the stock price is currently under-valued or over-valued in the market.
- (See Section 9.3: Required Returns in your course text.)
- State your recommendation for your concluded stock price for the company.
- Use either the high-end stock price or the low-end stock price from the constant growth formula using the CAPM required rate of return.
- Justify the conclusion of value for your stock based on the most important financial facts from the prior weeks’ analysis.
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The Section 4: Valuation Conclusion paper
- Must be two to four double-spaced pages in length including any tables or calculations (but not including title and references pages) and formatted according to APA Style (Links to an external site.) as outlined in the Writing Center’s APA Formatting for Microsoft Word (Links to an external site.)
- Must include a separate title page with the following:
- Title of paper in bold font
- Space should be between title and the rest of the information on the title page.
- Student’s name
- Name of institution (The University of Arizona Global Campus)
- Course name and number
- Instructor’s name
- Due date
- Title of paper in bold font
- Must utilize academic voice. See the Academic Voice (Links to an external site.) resource for additional guidance.
- Must include a separate references page that is formatted according to APA Style as outlined in the Writing Center. See the APA: Formatting Your References List (Links to an external site.) resource in the Writing Center for specifications.
- Must cite where the financial statement information comes from (e.g., Yahoo! Finance or Mergent)
- For help citing the information from Mergent, see the BUS401: Principles of Finance Research Guide.
Note: Since this is Section 4 of the Week 5 final project, there is no need for an introduction paragraph.
Carefully review the Grading Rubric (Links to an external site.) for the criteria that will be used to evaluate your assignment.
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