The cost of equity capital and the CAPM Essay Example | Topics and Well Written Essays - 1000 words

The cost of equity capital and the CAPM - Essay ExampleThe one-third or so popular methods include dividend exploitation model, capital asset set model and the arbitrage pricing model. Dividend product model Organizations utilize the cash generated for two purposes they either reinvest it in the growth or parvenu projects of the organization or pay some amount as dividend to the common stockholder. The Dividend growth model is establish on this premises that a shareholder of the organization will want both dividend as intumesce as capital appreciation date holding the stock. The cost of equity in this case chiffonier be given as (Weaver and Weston, 2004, pg.282) Where, R is the required rate of fall back Dcs1 is the dividend payout in year 1 Pcs is the price of the stock G is the growth rate in percentage terms One of the close important factors while sharp the required rate of return thru the dividend growth rate is the numeration of the growth rate, G. This is an estim ated growth rate and hence special precaution needs to be taken while figure R. The three options to estimate G are estimation of an internal growth rate, estimation from historical growth rates or by studying the growth rates stated by the management in the annual report. Because of the trickiness in estimation of the growth rate of the stock, the dividend growth rate is rarely utilise for the calculation of the cost of capital. The model is simplistic in nature which makes it very adaptable to many particularised situations. It is a more conservative model as compared to the other two. This model is effective in purpose low PE ratios and high dividend yield stocks to be undervalued. Capital Asset pricing model (CAPM) The CAPM approach of calculating the required return of a security is based on the premise that the expected return on a stock is a function of the return of the market and the sensitivity of the return of stock to changes in return of the market. For an individua l security the risk of the security can be thought of as a measure of ?. Because of diversification, the expected return on a security is positively related to its ?. The expected return on a security in this case can be given as CAPM is the most widely used method to calculate the expected rate of return or the cost of capital. some of the key assumptions on which CAPM is developed are All investors are thinking of the same period while deciding investments Investors choose their portfolios solely on the basis of expected returns and risks Investors can borrow or sum up unlimited amount of money at the risk free rate All investors are having uniform expectations. At the same time, all investors imbibe the required knowledge and information There are no transactional costs, taxes or restrictions on shorting a stock Investors are risk averse While CAPM is quite often used, it can be easily seen that most of the assumptions are very simplistic in nature and do not hold true for m any cases. At the same time, another problem that the CAPM is suffering from is the calculation of ?. While the CAPM equation suggests that ? should be forward looking, in reality, it is calculated from historical returns (Gitman, 2006, pg. 47). Still, most of the financial economists construe it as the best tool to calculate the retuired rate of return. Its validity has been proved by many studies that have indicated concurrence with