Question

2 paragraph explanation

Do you think that a one-factor model is sufficient to predict expected returns? What else, if anything, would influence your choice of equities? Why?

Answer 1

The one-factor model, called the capital asset pricing model (CAPM), was developed in the early 1960s. William Sharpe, Harry Markowitz and Merton Miller won the Nobel Prize in economics for this work. CAPM adds a single factor to the equation: risk as measured by standard deviation.

CAPM claims that riskier the stock, greater is the expected return.

E(R_i) = R_f + Beta(E(R_m)- R_f)

The cost of equity funding is determined by estimating the average return on investment that could be expected based on returns generated by the wider market.

General Factors that influence the Cost of equity are:

1. Market Conditions

There are two main conditions of market, i.e. boom conditions and bearish or depressed conditions. These conditions affect the cost of equity, especially when company is planning to raise additional capital. Depending upon the market condition investors may be more careful in their dealings.

2. Flotation Costs

Floatation cost is the cost involved in the issue of shares or debentures. These costs include the cost of advertisement, underwriting statutory fees, etc. It is a major consideration for small companies but even large companies cannot ignore this factor.

3. Rate of Interest

Rate of interest prevailing in the market is an important factor influencing cost of equity decision. If the market rate of interest is high the firm will prefer to depend on equity— conversely it will depend on debt.

4. Funds Availability

Availability of funds in the money market also determines the capital structure of the firm. If the money market squeezes, the firm may resort to equity. On the other hand, if supply of funds in the money market is abundant the firm may depend on debt.

5. Corporate Taxation & Dividend

Taxation policy of the government, such as on interest and dividend has sev­eral effects on capital structure. Interest charges are tax deductible and the use of debt securities thus provides a lower cost of financing than preferred stock or equity securities.