You have been asked to estimate the cost of capital for IBM. To help with this task you have been provided with a balance sheet (see below) and the following information:

• The beta of the stock is 1.09, based upon a regression of IBM stock returns against the S&P 500 Index.
• The share price is $130, and there are 943 million shares outstanding.
• The firm has $61.7 billion in debt on its balance sheet. Since the debt is mostly short-term or recently issued, one may assume that the book value of the debt provides a good approximation of its market value. IBM incurs a marginal corporate tax rate of 36%.
• The firm is rated A by the rating agencies, and the default spread over for A-rated 10-year bonds is currently 96 basis points over the corresponding US treasury yield.
• Ten year Treasurys currently yield about 4.40%, and the expected long-term return on the broad stock market is about 12%

IBM
12-96 12-97 12-96 as % of assets 12-97 as % of assets
Assets ($ mil)
Cash 8,137.0 7,553.0 10.03 9.27 Inventories 5,870.0 5,139.0 7.24 6.31 Other 26,688.0 27,726.0 32.89 34.02
Current assets 40,695.0 40,418.0 50.16 49.59 Non-current assets 40,437.0 41,081.0 49.84 50.41
Total assets 81,132.0 81,499.0 100.00 100.00
Liabilities & Shareholders’ Equity ($ mil)
Current liabilities 34,000.0 33,507.0 41.91 41.11 Long-term debt 25,504.0 28,176.0 31.44 34.57 Other liabilities 15,632.0 14,480.0 19.27 17.77
Total liabilities 75,136.0 76,163.0 92.61 93.45 Shareholders’ equity 21,628.0 19,816.0 26.66 24.31
Total liab. & equity 96,764.0 95,979.0 119.27 117.77
Balance Sheet Ratios
Current ratio 1.2 1.2 Debt/equity ratio 1.2 1.4

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