The Cost of Equity Capital and CAPM



Capital Asset Pricing Model

Part I:

Introduction

The rates of return play a key role in determining the value of the stock. The required rate of return (RRR) is a component among the metrics and its calculation is used in corporate finance and equity valuation. The required rate of return is the minimum return that an investor looks for, given the entire options that are available and the capital structure of the firm. Moreover, in recent years, there are three basic models through which RRR is calculated. All three methods have unique features for the company. Hence, in this paper we will discuss, the three models (dividend growth, CAPM, or APT) and which is the most beneficial for judging the required rate of return or discount rate for the company. Based on the analysis and findings, one method will be recommended to the board of directors for the company (Jagannathan, Ravi & McGrattan, 1995).

Discussion

The three methods are Dividend Discount Model (DDD), Capital Assets Pricing Model (CAPM) and Arbitrage Pricing Theory (APT).

Dividend Discount Model (DDD)

Dividend Discount Model (DDD) is method to value the price of the stock by using the forecasted dividends and discounting them back to their present value. In order words, it offers a simple approach to value the stock with the dividend growing at a stable rate.

Moreover, if the value of the stock attained from the DDM is lower than what the share presently trading at then the stock tends to be overvalued.

DDM has many variations and it is not good for that company that does not distribute dividends to their share holders. For instances, one deviation is the supernormal dividend growth model which take in to the consideration of high growth period followed by the lower constant growth period. The net present value of the cash flow is the main principle behind this model. In order to obtain the growth number, one way is to take the return on equity and multiply it by the retention ratio (Reilly, Frank K. et al., 2003).

In order to implement the DDM, it is necessary for the company to have

Expected dividends one year from now (D1)

The Dividend Growth Rate (GR)

Your required Rate of Return (RR)

Without these things, company cannot determine and implement this model in their company. Moreover, the main aim of this model is to estimate the present value of the future dividend. It should be noted that this model is only for those companies that pay dividend or tends to pay dividends in future. The investment value is the expected cash flows, in this circumstances the dividends are discounted at the rate which compensate for the risk the share holders taking (Bruner, Eades, et al., 1998).

Moreover, this increase the confident of the shareholders as calculation through the DDM can decide that the investment in this company is beneficial or not. Therefore, when the investment is overvalued, an investor will considered to move on to other ...