Question

In your analysis of the cost of capital for an ordinary share, you calculate a cost capital using a dividend discount model that is much lower than the calculation for the cost of capital using the CAPM model.

1. Explain <using max 50 words> possible sources for the discrepancy.

Answer 1

Answer.

The dividend capitalization model can be used to calculate the cost of equity, but it requires that a company pays dividends. The calculation is based on future dividends. The theory behind the equation is the company's obligation to pay dividends is the cost of paying shareholders and therefore the cost of equity. This is a limited model in its interpretation of costs.

The capital asset pricing model, however, can be used on any stock, even if the company does not pay dividends. That said, the theory behind CAPM is more complicated. The theory suggests the cost of equity is based on the stock's volatility and level of risk compared to the general market.
The risk-free rate is the rate of return paid on risk-free investments such as Treasuries. Beta is a measure of risk calculated as a regression on the company's stock price. The higher the volatility, the higher the beta and relative risk compared to the general market.

Hence, the higher cost of equity on such shares is due to the beta factor involved which makes it more volatile to market risk premium considerations.