Question

Cost of equity is estimated by two models. How is risk explicitly and implicitly incorporated in each of the two models?

Stock prices fell drastically in March after the pandemic spread and the economy came to a grinding halt. Explain this phenomenon.

Why have the stock prices gone up significantly during the month of May and June ?

Please answer the question in detail using finance terminology

Answer 1

1.Cost of equity can be calculated using either of the following model;

i)CAPM(Capital Asset Pricing Model)

ii)Dividend Capitalization Model

CAPM takes into account the riskiness of an investment relative to the market.CAPM formula is;

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

In this formula,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.In general a company with a high beta,that is,a company with a high degree of risk will have a higher cost of equity.

Dividend capitalization model only applies to those companies that pay dividend and also assumes that the dividend will grow at constant rate.Dividend capitalization formula;

Cost of equity=Dividend per share for next year/(current share price-dividend growth rate)

This model is simple and convenient but it is extremely sensitive to the inputs of growth rate.This model does not account for investment risk to the extent CAPM does,since CAPM require beta.