Question

Explain the benefits and limitations of using :

(1) Capital Asset Pricing Model to calculate cost of equity

(2) Dividend growth model to calculate cost of equity

(3) bond plus risk premium model to calculate cost of equity

Provide a well detail answer and no copy and paste.

Answer 1

Answer:-

1) Capital Asset Pricing Model

Benefits

a) CAPM is a very easy to calculate and widely used model to calculate cost of equity
b) This model take into account the systematic risk beta which is not taken for evaluation in other models
c) This model eliminates the unsystematic risk which can be diversified

Limitations

a) The risk free rate that is used for evaluating is volatile and changes frequently
b) The CAPM model takes into account unrealistic assumptions for calculating the cost of equity
c) In this model sometimes it is difficult to determine the beta when valuing the companies.
d) This method may be simple but have low explanatory power

2) Dividend Growth Model

Benefits

a) This model is easy to use as the investors to calculate the growth of his stock.
b) This model can be used to value market indices
c) This model can be used to value companies with multiple stages of growth like early stage, growth stage and mature stage.

Limitations

a) This model does not take risk into consideration
b) It can be used for only dividend paying companies
c) It cannot be used for companies when the dividends paid are volatile ie they are not constant with the profits of the company.
d) This model valuations are sensitive as the growth rate and required rate of return which cannot be precisely estimated

c) Bond plus risk premium model

Benefits

a) It can be easily used for closely held companies when the beta is not available
b) This method is the most appropriate for the companies which has publicly traded debt.
c) It is simple method as the required return can be easily calculated by adding up the the values of risk free, equity risk premium, size premium and the specific company premium.

Limitations
a) This method uses historical values as estimates which may not be relevant for the current period of time.
b) The estimation of size premium my not be accurate which is estimated based on the size of the company