Estimating Firm Cost of Equity for Nova Scotia Bank

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 3.4 Estimating Firm Cost of Equity

3.4.1 Introduction

Investors demand a rate of return from holding a company's equity, compensating for

ownership risks. It is crucial to Nova Scotia Bank's Cost of capital and capital planning and

financing decisions. Unlike debt, equity has an opportunity cost but no contractual duty to pay.

The Cost of Equity helps us assess the firm's financial attractiveness to equity holders, enabling

strategic movements like acquisitions, share buybacks, and dividends. The Cost of Equity and

Debt and WACC complete Nova Scotia Bank's financial picture (Doğan, B., & Acar, M. 2020).

A detailed assessment helps management make choices and gives investors insight into the

bank's equity risks and returns.

3.4.2 Methodology

We will use the Security Market Line (SML) calculation, based on the Capital Asset

Pricing Model, to estimate Nova Scotia Bank's Firm Cost of Equity. This option is based on its

widespread use in finance and academia to measure the equity risk premium. The SML

calculation matches the firm's Cost of Debt and Weighted Average Cost of Capital (WACC),

guaranteeing consistency across all capital structure components. The SML approach combines

Beta, the risk-free rate, and the market risk premium to calculate equity capital costs (Killins, R.

N., & Mollick, A. V. 2020). This method lets us estimate Cost using market volatility, investor

expectations, and economic variables.

3.4.2.1 Formula

The Security Market Line (SML) formula for evaluating equity cost is:

cost of equity=risk free rate+¿ )

  Risk-Free Rate: We will use a 10-year government bond yield to estimate risk-free rate.

Methodological consistency is achieved by following the Cost of Debt and WACC

norms.

 Market Risk Premium: The historical average difference between annual returns on a

broad market index (e.g., S&P 500) and the risk-free rate will determine the market risk

premium.

 Beta: Beta measures Nova Scotia Bank's market volatility or systematic risk. We will get

Beta values from trustworthy financial databases.

3.4.3 Data Sources

Accurately estimating Nova Scotia Bank's Firm Cost of Equity requires reliable and

current data. To do this, we used the following key data sources:

Risk-free rate: The Central Bank's publications or Bloomberg and Reuters financial market

databases will provide the 10-year government bond yield.

Market risk premium: The market risk premium will be calculated using historical annual returns

of a broad market index like the S&P 500. Academic papers and financial databases like Yahoo

Finance and Morningstar will provide this data (Engle, R. F., & Jung, H. 2023).

Beta Value: Nova Scotia Bank's Beta value will be derived and updated from Bloomberg,

Reuters, or Morningstar.

Historical Financial Reports: Nova Scotia Bank's financial statements and annual reports will be

reviewed for particular calculation information. The bank's investor relations webpage has these

reports.

Peer review journals: Financial economics and capital market research peer-reviewed journals

will be used for methodological validation and cross-referencing (Gehrig, T. 2023).

Industry Reports: Market research firms and financial experts offer industry reports on sector-

specific hazards and market developments that may affect the bank's equity risk.

3.4.4 Data and Calculation

The following data points were collected from the identified data sources:

 Risk-Free Rate: 1.5% 10-year government bond yield.

 Market Risk Premium: The S&P 500's 10-year annual results show a 5%

market risk premium.

 Beta value: According to financial databases, Nova Scotia Bank's Beta

value is 1.2.

We'll calculate the Cost of Equity using the Security Market Line (SML) formula:

cost of equity=risk free rate+¿ )

Data table

The following table highlights Nova Scotia Bank's Cost of Equity calculation data:

Parameter value Source Description

Risk-free rate 1.5% 10-year government bold yield The risk-free rate is usually
estimated using a 10-year
government bond yield.
Market risk 5.0% Historical annual return of S&P The average stock market
premium 500 return is risk-free.
Beta value 1.2% Financial databases, eg, yahoo A comparison of the stock's
finance , Bloomberg excess return to the
market's.
Calculation

Using the data, we can determine Nova Scotia Bank's Cost of Equity using the Security

Market Line (SML) formula:

cost of equity=risk free rate+¿ )

cost of equity=1.5+(1.2∗5.0)

cost of equity=1.5+6.0

cost of equity=7.5 %

Interpretation

Nova Scotia Bank stockholders expect a 7.5% return on their investment. For the firm,

this information sets the bar for acceptable investment opportunities and helps evaluate new

projects. A project with a projected return above 7.5% would benefit the firm and shareholders.

Sensitivity Analysis

The Beta and Market Risk Premium affect the Cost of Equity. Changes in these

parameters impact the estimated value. These statistics should be reviewed and updated routinely

to maintain an appropriate Cost of Equity.

3.4.5 Results

According to our calculation, the Cost of Equity for Nova Scotia Bank is 7.5%. This is

important because the Cost of shares defines the minimal rate of return shareholders expect for

investing in bank shares. To optimize shareholder value, the bank should achieve a return greater

than this calculated Cost of Equity from any investment possibilities or strategic initiatives (Ho
et al., 2023). This statistic is crucial to the Weighted Average Cost of Capital (WACC), the

bank's funding cost. Understanding the Cost of Equity helps Nova Scotia Bank balance and

optimize capital allocation, improving long-term sustainability and growth.

The Cost of Equity discounts mergers & acquisitions, capital expenditures, and other

strategic investments. A project or venture that generates a return higher than the Cost of Equity

is usually pursued by shareholders. We use the Security Market Line (SML) technique to ensure

consistency and compatibility with other project components. Thus, Nova Scotia Bank's Cost of

Equity is robust and aligned with its financial framework.

3.4.6 Observations and Analysis

The 7.5% Cost of Equity gives us important financial market data regarding Nova Scotia

Bank. At this rate, shareholders expect a 7.5% equity return, which management uses to make

investment decisions. This moderately high score shows the market perceives a considerable risk

linked with the bank's operations or future cash flows. This could be due to market instability,

competition, or regulations. The high Cost of Equity suggests that shareholders demand a bigger

reward for taking on the perceived risk, raising the bar for the bank's strategic undertakings. The

Cost of Equity will also affect the WACC, raising capital costs and potentially hurting the bank's

competitiveness (Kaur, J. 2019). If the bank can generate returns up to this level, it may have

trouble attracting equity capital or retaining shareholders, which could hurt stock prices.

The bank's Beta and Market Risk Premium also affect the rate. Any changes in these

characteristics will dynamically change the Cost of Equity, affecting investment and strategic

planning. Thus, these factors should be examined often to update financial indicators. Our Cost

of Equity estimate, Cost of Debt, and WACC provide a complete picture of the bank's financial
health and performance. This consistency makes our analysis dependable for internal decision-

making and outward communication.

3.4.7 Comparison with Previous Sections

The Cost of Equity, Debt, and Weighted Average Cost of Capital are used to estimate Nova

Scotia Bank's Cost of Capital. The components' relationships and differences:

Alignment with capital structure: The Cost of Equity matches Monica's capital structure

from section 3.1. Since stock is a large portion of the bank's capital structure, a greater stock cost

would raise the WACC, making capital-intensive projects less attractive.

Comparative Risk: Equity holders carry more risk than debt holders. Hence, the Cost of

Equity is more than the Cost of Debt, which is cheaper and tax-deductible. Residual claimants

take more risks.

Market Dynamics: Market conditions affect debt and equity costs differently. The Cost of

Debt depends on interest rates and bank credit rating, whereas the Cost of Equity is more volatile

and depends on market risk premiums and beta value.

Consistency in methodology: We estimate the Cost of Equity using the Security Market

Line (SML) model, maintaining methodological consistency with prior parts. Our study is more

reliable since diverse components are calculated using a unified framework.

Impact on WACC: The WACC is calculated using the Cost of Equity and Debt. Both

indicators must be estimated for an accurate WACC, the entire asset financing rate a corporation

must pay.

Financial Planning: Cost of Debt, Cost of Equity, and WACC are essential for the bank's

financial planning and investment decisions. Incorrect assessment in any of these can lead to bad

investments and strategic mistakes.

 Investor Expectations: The Cost of Debt and Cost of Equity set the bank's debt and equity

returns (Jorgenson et al., 2023). These indicators all focus on satisfying investor expectations for

risk-adjusted returns.

3.4.8 Conclusion

In conclusion, Nova Scotia Bank's capital structure and financial stability depend on the

Cost of Equity. The Security Market Line (SML) model allows us to analyze the Cost of Debt

and WACC consistently and comparably. Equity capital is riskier than debt. Therefore, our

estimations reflect this. Combining Cost of Equity, Debt, and WACC provides a holistic

perspective of the bank's capital expenses, enabling stakeholders to make educated decisions and

plan forward.
 References

Doğan, B., & Acar, M. (2020). The impact of corporate governance on Cost of capital: an

application on the firms in the manufacturing industry in Borsa Istanbul. Centre for

European Studies (CES) Working Papers, 12(1).

Engle, R. F., & Jung, H. (2023). Estimating SRISK for Latin America. Available at SSRN

4381427.

Gehrig, T. (2023). Leverage, Competitiveness, and Systemic Risk in Banking. Available at

SSRN 4479186.

Ho, T., Nguyen, T., Nguyen, Y., & Brownen-Trinh, R. (2023). How Do Equity Research

Analysts Value Banks? Evidence from North American and European Banks.

Jorgenson, D. W., Weitzman, M. L., ZXhang, Y. X., Haxo, Y. M., & Mat, Y. X. (2023). BNS:

TSX Bank of Nova Scotia (The). AC Investment Research Journal, 220(44).

Kaur, J. (2019). Financial Distress and Bank Performance: A Study of Select Indian

Banks. International Journal of Financial Management, 9(3).

Killins, R. N., & Mollick, A. V. (2020). Performance of Canadian banks and oil price

movements. Research in International Business and Finance, 54, 101258.