The cost of equity capital and the CAPM

Title : Comparing the dividend growth and CAPM Approaches to evaluating the cost of equity capital A report

Summary

The dividend growth model and the CAPM are comparatively explored as alternative approaches to calculating the required rate of returns on investments . The CAPM is found to be an advancement being free from the very restrictive drawbacks of the dividend growth model of requiring constant dividend payments to be satisfied . A way of evaluating the cost of equity of a company that does not have its stocks traded in the market is briefly

mentioned (1 ) The Dividend growth model

The dividend growth approach to valuation of a stock is based upon the notion that its intrinsic value is essentially the present value of the future stream of income expected from the stock . This approach is based upon the following assumptions

1 . The stock under consideration is to be held over an infinite period of time

2 . The stock yields a dividend (Di , i 1 , 2 ) payment annually over its infinite lifetime

3 . In equilibrium the intrinsic value (V ) of the stock equals its market price (P

4 . The growth rate of the dividends is constant (g ) and is lower than the discount rate (k

To perceive the necessity of these assumptions we have to go through the mechanism of the derivation of the valuation formula . Based upon such assumptions , the intrinsic present value of the stock at period '0 ' is given by the equation Similarly ,Putting these relations in the expression for V0 Similarly , we arrive at This leads to Now , for constantly growing dividends , we have (since k g is assumed

So This is the expression for the value of the stock in the dividend growth approach . Here , k is the required rate of return and the cost of equity for the company in question . Evidently with information about the dividend return in the next period , the market price of the stock and the growth rate of the dividend , the required rate of return can be calculated by solving for it from

k D1 /P0 g

This approach has the great advantage of being extremely easy to compute as it involves a very easy formula . However , I do feel it to be inappropriate to apply for the valuation of our company primarily because it requires constant growth of dividends and moreover that rate has to be lower than the cost of equity capital for the formula to be applied . This perpetual constancy of dividend growth is very unlikely to be met . Moreover , this approach is applicable only if the company pays dividends and that too at a constant growth rate . Another large drawback is that the risk involved in investing is excluded although that does play a large role in determining the choice of the investor (Gordon 1962 (2 ) The CAPM

The Capital Asset Pricing Model (CAPM ) determines the optimality of an investment through analyzing the expected returns and risk relationship It is advancement over the dividend growth model in that...