The cost of equity capital and the CAPM - Essay Example

The three most popular methods include: dividend growth model, capital asset pricing model and the arbitrage pricing model. Dividend growth model Organizations utilize the cash generated for two purposes: they either reinvest it in the growth or new projects of the organization or pay some amount as dividend to the common stockholder. The Dividend growth model is based on this premises that a shareholder of the organization will want both dividend as well as capital appreciation while holding the stock.

The cost of equity in this case can be given as (Weaver and Weston, 2004, pg.282): Where, R is the required rate of return 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 most important factors while calculating the required rate of return thru’ the dividend growth rate is the calculation of the growth rate, G. This is an estimated growth rate and hence special precaution needs to be taken while calculating 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 used for the calculation of the cost of capital. The model is simplistic in nature which makes it very adaptable to many specific situations. It is a more conservative model as compared to the other two. This model is effective in finding 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 individual 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 lend unlimited amount of money at the risk free rate All investors are having homogenous expectations.

At the same time, all investors have 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 frequently used, it can be easily seen that most of the assumptions are very simplistic in nature and do not hold true for many 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 consider 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