The cost of equity essay
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The application of Capital Asset Pricing Model, Dividend Growth Model and Arbitrage Growth Model in estimating the rate of return that one feels company investors require as the minimum rate of return in terms of the relative investments required for investors in a company to earn on their investment in form of shares in the company. It is important to note that the investment is not the amount shareholders spent buying the share of the company in the past rather the true investment is in terms of today's share prices because shareholders could have sold their shares today, and if they decided to hang on to these shares instead of selling these shares off this is their true investment in the shares of the company as of today. In this paper it is established that the Dividend growth model provides a better option for estimating rate of returns due to its relatively futuristic element compared to Capital Asset Pricing Models and Arbitrage Growth Models.
Ease of use of these three models
Capital Asset Pricing Model
According to Madura (2008), “The CAPM is based on the premise that only important risk of a firm is systematic risk, or the risk that results from exposure to general stock market movements” (Madura 267). He further adds that, “The CAPM is not concerned with so called unsystematic risk, which is specific to an individual firm, because investors can avoid that type of risk by holding diversified portfolios” (Madura 267). This implies that during an adverse condition in the market that potentially affects an individual element of a firm the investor is given an option of offsetting the affected factor with another favorable element affecting the firm.
Dividend Growth Model
The Dividend growth model relies upon the fact that values of the share of individual members who are essentially investors are worth the future cash flow projections which are based on generation of the firm’s discount rate.
Arbitrage Pricing Theory
Arbitrage Model Theory has been found to enable investors to diversify their options by enabling them to choose individual systematic profiles in terms of risk and returns through selection of portfolios matching the relative arrays of betas (Goetzman). However, with regard to security market lines, Arbitrage Pricing Theory appears to be relatively similar to Capital Asset Pricing Model since the relative discount rates provided are essentially based upon the progressive risk of the security itself as opposed to utilization of total risk (Goetzman). In addition, Arbitrage Pricing Theory holds significant advantages in terms of providing short selling options in which an individual has the right of returning similar shares from a stock in futuristic dimensions.
These models provide some insights and tools to estimate the rate of return that investors in our company 'require' in the sense that if they don't see the possibility that they'll earn that rate of return they'll sell the shares and that of course will lower the market price per share
Choose the best method for estimating the required rate of return/discount rate
The best method for estimating the rate of return or discount rate is the Dividend Growth Model by virtue of it taking into account all the applicable inputs which can be ascertained, for instance, the cash flow per period and the discount rate. This is attributed to the fact that the periodic cash flow usually equates the projected dividends to be received received.
Accuracy of each of these three models
How realistic the assumptions of each model are
Capital Asset Pricing Model
In as much as Capital Asset Pricing Model appears to provide sustainable answers concerning risk based on the needed rates of return, there are significant doubts regarding the measurement of the inputs needed for the actual implementation of Capital Asset Pricing Model. For instance, according to Brigham and Ehrhardt (2008), “These inputs should all be ex ante, yet only ex post data are available…Thus, although the CAPM appears precise, estimates of rate of return found through its use are subject to potentially large errors” (Brigham & Ehrhardt 264).
Dividend Growth Model
The dividend Growth Model relies on the assumption that the dividends increase at a constant rate according to the constant growth rate in order to determine the future value of equity. In order to establish the relative accuracy of the model in regard to the presented constant growth dividend model there is need to establish certain variables according to Correia et al (2007): “The next year’s dividend [current dividend × ( 1 + growth rate)]; the discount rate (i.e. the cost of equity); the growth rate in future dividends” (p.6-13). In real sense estimating the growth rate is not an easy task hence the assumption that the growth rate can be constant is not entirely correct or realistic. This factor may only be applicable in companies operating in certain specific sectors of the economy where real growth rate can be equated to the actual GDP growth rate.
Arbitrage Pricing Model
According to Brigham and Daves (2008), “The primary advantage of the APT is that it permits several economic factors to influence individual stock returns…Finally the APT does not assume that all investors hold market portfolio, which is a CAPM requirement that clearly is not met in practice” (Brigham & Daves 98).
Application of the dividend growth model
The dividend growth model is relatively easy to comprehend and apply as compared to the other methods. This method can be only be used in companies that are currently paying dividends. In addition to this the dividends must show a constant growth rate. This method does not consider risk explicitly. Therefore it is mostly applied in mature companies which are characterized by moderate growth rates. This model takes into consideration that the customer expects cashflow as dividends during the period he holds the stock and at the end of this holding period (Carlos 6-11). This method asserts that the value of a stock is the current dividends values through infinity. The rate of return of a stock is influenced by its riskiness. The model is flexible because it allows for varying discount rates on a particular time period. There are four versions of this model; the Gordon growth model, the two-stage dividend discount model, the H model and the three stage model. The Gordon growth model assumes that the value of the firm will increase at a steady rate whereas the two-stage dividend model assumes that the company growth is based on two phases. The initial phase is expected to pose very slow or negative growth rate but after a few years the company enters the second phase characterized by a steady and stable growth rate. This situation occurs in rare cases because most companies make a gradual transition to steady growth rate. The H model is also a two stage model but unlike the two-stage model growth declines lineally to a stable and steady rate.
This model assumes that growth in earnings start at a high rate and gradually decline to a steady rate. In addition to this it assumes that cost of equity and dividends remain constant despite the shifts in growth rate. The three stage growth model is a combination of the H and the two stage model. This model allows for the initial high growth period which is succeeded by a period of decline and finally moves on to a period of steady ad stable growth phase.
Chandra explains that the dividend growth model assumes that firms have a definite life which enables individuals assume a constant growth rate to estimate expected dividends at the firms cost of equity (100). This method is easy to use and understand.