Module 3



Module 3 - Case

Part I: Required Rate of Return

Introduction

There are two factors on which the investment value depends on and these are net expected benefit and required return of rate. When investors decide to invest in any projector companies, the first thing they look is the rate they will be receiving from investment. There are various methods through which required rate of return can be obtained. But the basic models and methods which usually opted by companies due to their unique features are Dividend Growth, Capital Asset Pricing Model and lastly Arbitrage theory. Among these, which model is the best one for estimating the required rate of return (or discount rate) for the Wal-Mart would be the main objective of this part. On analysis of these three methods and models, one method will be recommended to the Wal-Mart board of directors.

Discussion

Dividend Discount Model - (DDD)

Dividend Discount Model measures the present value of the stock grounded on the dividend growth rate. This method is suitable to those capitalists which are income investors. Furthermore, if the stock value from DDD is lower than the value of stock that is trading in the market, then the stock leads to be overvalued and so on. There are various fluctuations associated with this method and it is not good for companies that do not distribute dividends to shareholders.

One case is related to the supernormal dividend growth model where high growth takes place just after the lower constant growth period. The main principle behind this model is the net present value of cash flows. In order to obtain the growth number, one way is to take the return on equity and multiply it by the retention ratio.

Nevertheless, there are DDM models, one is Gordon model which is very simple and popular model used by companies and other is the two-step model -Two-stage model in which excessive growth take place. For implementation of DDM, it is essential that company must be paying dividend to the shareholders and if they are not, then other approach would be applicable. The main features of DDM are:

Expected dividends one year from now i.e. D1

The Dividend Growth Rate i.e. GR

Required rate of return i.e. RRR

Furthermore, it should be note that DDD has certain warning related to dependency and growth rate and lacking of above main features companies cannot use and implement this model in company (pages.stern.nyu.edu).

Capital Assets Pricing Model - CAPM

The relationship between risk and return is determined through Capital Assets Pricing Model. This is used to price the securities and stocks or used to measure the financial assets. In order words it can be in this way that, it is used to assess the profitability realized by a fund over a given period. The formula for CAPM is:

E (Ri) = Rf + ßi (E(Rm) - Rf)

The idea behind this CAPM concept is the compensation of investors. This compensation is in two ways, one way is the time value of money and other is ...