Finance

In calculating cost of equity for this company Capital Asset Pricing model is used. This model estimates profitability of financial assets that are used. This model is used as a theoretical basis for a number of various financial methods of earnings and risk management in a long-term and mid-term investment decisions. CAPM considers profitability of assets depending on the market behavior as a whole( Fama and  French, 2004, p. 26).

According to CAPM the risk from investing in any financial tool can be divided on two kinds of risk systematic and non-systematic. The systematic risk is caused by the general market and economic changes which are influencing all investment tools. This risk is not unique for a particular company or asset. The non-systematic risk is closely connected with the concrete company-emitter.

It is impossible to reduce systematic. However, it is possible to measure how market correlates with a profitability of companys financial asset. As a measure of non-diversifiable risk in CAPM is used  (Beta) coefficient that characterizes the sensitivity of company financial asset profitability to the changing market portfolio profitability. By knowing the  coefficient for a particular company financial stock or asset, it is possible to estimate the quantitative risk for this asset connected with changing prices of the market as a whole. The Beta for market equals 1. If Beta for company  1, then company stocks prices will go up and down by the same percentage as for market as a whole. If 1 then company stock prices are less sensitive to market movements, while if 1 they are more sensitive and therefore more risky ( Fama and  French, 2004, p. 26).

Johnson and Johnson s Cost of equity
The formula that will be used to calculate cost of equity for the company will be
Rj  RF  j RM - RF
Where as Rj is the cost of equity to be calculated.  RF is the risk free rate which is yield to maturity for one year USA Treasury bond. RM is the market rate or SP 500 rate and j is the company beta.
The beta of the company is 0.63(Finance yahoo, 2010) and yield to maturity for one year bond is 3.6 (bloomberg.com). The premium is 7 that is the difference between the market rate and the risk free rate.

Therefore, expected Return on equity  3.6  0.63  7  8.1
Cost of equity and weighted average cost of capital
Cost of equity obtained is lower than what I expected because the use of one year yield to maturity and it has a beta of less than one. It is important to note that a beta of less than one means that the company is less risk than the market it self. Therefore it is expected to a lower risk than 10.2 which is the average market rate.

Cost of equity of other two companies
The company JW Surety and Treasury Bonds whose Betas are 1.53 and 0.13 respectively. The expected returns are for these companies
JW Surety expected Return on equity  3.6  1.53  7  14.31
Treasury bond  expected Return on equity  3.6  0.13  7  4.51
Am not surprised with results as their betas are first case higher and the second case higher.
Dividend growth model and arbitrage pricing model

Arbitrage Pricing Model defines the risk premium as follows Risk premium  b1 (premium1)  b2 (premium2)  b3 (premium3) .... The APM defines the risk premium by specific pervasive macroeconomic factors and their individual weights. There is no need to be concerned with measuring a market portfolio or dig deep in the theory about investor behavior as the model is based on the absence of arbitrage opportunities it fails, however, to give an explicit prescription about which factors to use and how they are weighted. This gives the model a general appeal, but at the same time makes it difficult to apply in practice. Empirical attempts at identifying the factors have been made, but with limited success.

Dividend growth model The concept behind this model of investing is to buy a solid share with tracks of increasing dividend annually. The increase rate of dividends would likely support higher stock prices over long term as many investors were searching for attractive yields. The model is proven to be prudent since the increase of dividend rate will also increase ones yield as a percentage of a purchase price.