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The cost of equity capital and the CAPM
Finance & Accounting
Pages 4 (1004 words)
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 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. ...
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