Figure 1: Historical descriptive statistics of various portfolios/assets (January 2001 December 2010) ri Mean Variance rmkt - rf rSMB rHML

L 0.003999 0.000940 rf 0.001799 0.000002

0.007811 0.001981 0.005768 0.005779 0.002456 0.000761

Standard 0.076020 0.049557 0.027590 0.0360663 0.001456 deviation

a) Equity cost of capital: Method 1: CAPM and SML

Security excess returns against market excess returns

0.30 0.20 Security excess return 0.10 0.00 0.00 -0.10 -0.20 -0.30

-0.20

-0.15

-0.10

-0.05

0.05

0.10

0.15

Market excess return

Excel Regression Output Standard Coefficients Error t Stat 0.006560527 0.006356799 1.032048937 0.631214618 0.128706265 4.904303729

Intercept rmkt - rf

E(Ri) = rf + i[E(Rmkt) - rf] E(Ri) = rf + 0.6312[E(Rmkt) - rf] E(Ri) = 0.001799 + 0.6312*[0.001981] E(Ri) = 0.003049 (or 3.66% per year)

Method 2: Fama-French Three Factor Model Intercept rmkt - rf SMB HML Coefficients 0.005279033 0.647797879 -0.107469417 0.467238553 Standard Error 0.00645439 0.135116046 0.24267452 0.205110496 t Stat 0.817898152 4.794381551 -0.442854144 2.277984607

E(Ri) = rf + mkt[E(Rmkt) - rf] + SMBE(RSMB) + HMLE(RHML) E(Ri) = rf + 0.46724*[E(Rmkt) - rf] + 0.64779*E(RSMB) - 0.10747*E(RHML) E(Ri) = 0.001799 + 0.46724*[0.001981] + 0.64779*0.005768 - 0.10747*0.003999 E(Ri) = 0.004331 (or 5.20% per year) b) Debt cost of capital: Bond yield = risk-free rate + credit spread Bond yield = 0.001799 + 0.00125 Bond yield = 0.003049 (or 3.6588% per year) rD = yield pL, where p = prob of default, L = expected loss per $1 if default occurs rD = 0.036588 - 0.004*0.6 = 0.034188 (3.4188% per year) c) Weighted average cost of capital (WACC): Market value of equity, E = share price x number of shares outstanding = $53.7 x 397,120 = $21,325,344,000 = $21,325m Market value of debt, D = $996,500,000 = $996.5m

t C = Corporation tax rate = 35%

rWACC =

E D rE + rD (1- t C ) E+D E+D

rWACC = 21,325/(21,325+996.5)*3.66% + 996.5/(21,325+996.5)*3.42*(1-0.35) = 3.6% (using CAPM) rWACC = 21,325/(21,325+996.5)*5.2% + 996.5/(21,325+996.5)*3.42*(1-0.35) = 5.067% (using Fama-French) Use the Fama-French rWACC as the discount rate it has a higher R2 coefficient

Credit spread taken from coursework brief

d) Calculations, proxies, assumptions and use of data: To estimate the risk- free rate a one month treasury bill rate was used. USA government securities are typically treated as risk free since payment to investors is always guaranteed. The value weighted portfolio of the 500 largest U.S stocks (S&P 500) is used to represent the market portfolio as they are highly correlated. Finally, past returns are used to provide a good estimate of future returns. More detail on the calculation for each part is given below.

Part a): Linear regression was used on the data of past returns to estimate beta for the CAPM. This technique is used to identify the best fitting line (as shown in part a). The Fama-French factor betas were estimated by using multiple regression analysis. Historical averages were used (from figure 1) to estimate expected portfolio (SMB and HML) or expected market excess returns to be used as model inputs.

Part b): Bond yield was calculated as the risk-free rate plus the credit spread. Stryker Corp industry is a world leading medical technology company so the data for large manufacturing firms credit spread was used instead of the data for financial services firms. Since bond rating of BBB- credit spread was unobtainable, BBB credit spread was used as a proxy as it is the closest estimate.

Part c): The Market value of debt is assumed to consist of long-term debt only. An appropriate rate of tax of 35% was assumed for Stryker Corporation since this is the U.S corporate tax rate.

e) Limitations and refinements: Limitations: There is a beta estimation error. When estimating cost of equity capital with CAPM and APT results show low R2 coefficients and high standard errors in estimates which can indicate that these models are not sufficiently accurate. CAPM has a number of unrealistic assumptions such as using historical returns patterns as an assumption for future returns, as the

pattern might not repeat in the future. Moreover, the market portfolio proxy may not be mean-variance efficient - as assumed by the CAPM - because it does not include every observable asset (Roll, 1977)1. Refinements: To eliminate the beta estimation bias by using an adjusted beta formula as suggested by Pagano and Stout (2004)2. Also, try to control for the financial crisis which skewed market returns downwards (when calculating E(Rmkt)) and lowered the risk-free rate of return to zero for several periods.
1

Roll, R., 1977. A critique of the asset pricing theory's tests Part I: On past and potential testability of the theory. Journal of Financial Economics, 4(2), pp. 129-176. 2 Pagano, M. and Stout, D., 2004. Calculating a Firms Cost of Capital. Management Accounting Quarterly, 5(3), pp. 13-20.