Financial Management

Financial Management

2006

Financial Management

The capital asset pricing model (CAPM ) can be used to determine the required rate of return of a company . The CAPM determines the required rate of return or kS which is computed by using the formula : riskless return [ (expected market risk premium ) x Beta ] or RF [ (kM - kRF x Beta ] . IBM 's riskless return (kRF ) on a U .S . 10-year Treasury bond is equal to 4 .78 . A 7 .5 market risk premium (kM ) is assumed and Beta (60-month ) of 1 .64 . IBM

's required rate of return (kS ) using the CAPM is 9 .24 , calculated as follows

kS RF [ (kM - kRF ) x Beta]

kS 4 .78 [ (7 .5 - 4 .78 ) x 1 .64]

kS 4 .78 4 .46

kS 9 .24

The Capital Growth Model (CGM ) or the Gordon Model is used to compute for the current stock price or stock value based on dividends . CGM can be used to determine IBM 's current stock price or PO . PO is calculated by the formula : dividend in a given period (expected security return - dividend growth rate ) or D1 (kS - g . IBM 's current dividend (D1 ) is 0 .80 per share . The expected security return (kS ) computed above using the CAPM is 9 .24 and the given dividend growth rate (g ) of IBM for a 3-year period is 8 .2 . IBM 's stock value using CGM is computed below

PO D1 ( kS - g

PO 0 .80 ( 0 .0924 - 0 .082

PO 0 .80 / 0 .0104

PO 76 .92

IBM 's current stock quote as of November 30 , 2006 is 91 .92 while IBM 's stock price computed above using the CGM is 76 .92 , resulting to a difference of 15 . The difference in stock price is due to many factors The assumed market risk rate of 7 .5 can affect the computed stock price using the CAPM and the CGM . A stock is usually worth what somebody is willing to pay for it . The price of stock is determined by the buyer and the seller and by its supply and demand . The supply of any stock is limited so when the stock price gets so low that investors begin to buy more stocks , then its time for the company to increase its stock price

When the market risk premium (kM ) increases , the required rate of return (kS ) also increases . The stock price declines when the required rate of return (kS ) increases . Below is the computation of the stock value using a 10 market risk premium (kM with all other data remains the same

kS RF [ (kM - kRF ) x Beta]

kS 4 .78 [ (10 - 4 .78 ) x 1 .64]

kS 4 .78 8 .56

kS 13 .34

PO D1 ( kS - g

PO 0 .80 (0 .1334 - 0 .082

PO 0 .80 .0514

PO 15 .56

The price to earnings (P /E ) ratio is used for measuring market performance . It is the price of one dollar of current earnings and...