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
Part I Introduction While evaluating investment opportunities, it is necessary that we analyze the risk and return of all the options. Generally, the return on an individual security can be expected to be a measure of the security’s return. Moreover, when an individual holds a portfolio of more number of stocks will also be interested in analyzing the contribution of the individual stock to the risk and return of the entire portfolio…
The Capital Asset Pricing Model (CAPM)
For an open market place, an idealized framework is assumed. In this market, stocks available for trade are assumed to risky assets. Moreover, there are also those assets that are not associated to any risk and customers borrow whichever the quantity they want since there are no stipulations limiting quantities to be borrowed.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
If the actual return on a security is less than the required rate of return, the investors will sell the shares of that company and invest their funds elsewhere. Hence the concept of required rate of return in essential for a publically listed company. Determining a company's required rate of return can be a difficult task.
At stage 2, the firm and the merchant banker would reevaluate the firm’s decisions and terms of working for the investment banker and set the price. Stage 1 decisions determine the direction of fund raising, which gets
Diversification in the portfolio diminishes risk because prices of different stocks do not move exactly together or in the same direction always. There are two types of risks for investments. The unique risk or unsystematic risk is the risk that can be
ed risk if it invests in a number of projects with the view that even if the more risky projects perform badly, the less risky projects will cover up for the loss, resulting in an average return from the portfolio that is pretty much closer to what company expects i.e. cost of
The formula is given as: risk free rate added to beta multiplied by the difference of market return and risk free rate.
Beta in this case represents a stock’s rate of rise and fall in comparison to the market in general. It is a measure of the sensitivity of an assets
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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