The Cost of Equity of IBM from Two Perspectives.
You are valuing the stock of International Business Machines Corporation (NYSE:IBM) as of December 21,2001, and you have gathered the following information:
|
20 year T bond yield to maturity: |
5.8% |
|
IBM 8.375s of 2019 yield to maturity: |
6.238% |
The IBM bonds, you note, are investment grade (rated A1 by Standard & Poor’s and A+ by Moody’s Investors Service). The beta on IBM stock is 1.24.
1. Calculate the cost of equity using the CAPM. Assume that the equity risk premium is 5.7 percent.
2. Calculate the cost of equity using the bond yield plus risk premium approach, with a risk premium of 3 percent.
3. Suppose you found that IBM stock, which closed at 121.45 on December 21, 2001, was slightly undervalued based on a DCF valuation using the CAPM cost of equity from Question 1. Does the alternative estimate of the cost of equity from Question 2 support the conclusion based on Question I?