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Please respond to the following: Why might the constant dividend growth model (CDGM) and capital asset...

Please respond to the following:

Why might the constant dividend growth model (CDGM) and capital asset pricing model (CAPM) produce different estimates of the cost of equity capital used in the weighted average cost of capital (WACC)? Describe the difference between permanent and temporary working capital. What are some factors an organization considers when it chooses the mix of long- and short-term capital to finance the organization’s activities?

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Solution:

Part A)

Constant dividend growth model (CDGM) and Capital asset pricing model ( CAPM) give different cost of equity as they both use different parameters to estimate the cost of equity. Let's see both the formula

CDGM :

Share price = Dividend / (cost of equity - growth )

Cost of equity = Dividend / share price + growth

Here, the cost of equity will depend upon the dividend payout , growth and share price of the firm. These all are related with stock and not related with the market parameters.

CAPM :

Cost of equity = Risk free rate + Beta * ( Market return - Risk free rate )

Here, the cost of equity is dependent upon the market return, risk free rate and beta.

Since both the formula uses different parameters hence in calculation of WACC , when we use cost of equity then this cost is different in both the cases ( CDGM and CAPM )

Part B )

Permanent working capital are those capital that are required on a continuous basis to run the business. This can be seen as the minimum level of working capital that is required.

Temporary working capital is the excess capital over permanent working capital that is required. Let's assume when a company has sudden increase of demand due to seasonality then they will require more working capital and this can be termed as temporary working capital.

Part C )

Factors that can be considered while chosing the long term vs short term capital.

1. Utilization of capital : when capital is used to creat long term assets then we should go for long term capital. It can be achieved through equity capital or long term loan. When capital is used to create current assets that will be required for this current year then the firm should go for short term finance.

2. Cost : Cost of each capital is different and based on the existing structure of the firm we can decide for type of capital.

jeff jeffy answered 2 hours ago
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