Question

Q1-What are the criticisms of CAPM based estimation of required rate? Explain in detail.

Q2- What are the strengths of the two-stage DDM in comparison with the constant growth DDM. What are the weaknesses inherent in all DDMs?

Answer 1

Q1 - CAPM based estimation of required return : Re = Rf + beta (Rm - Rf),

Criticism :

• CAPM assumes that a security's required rate of return is based on only one factor (the stock market—beta). However, other factors such as relative sensitivity to inflation and dividend payout, may influence a security's return relative to those of other securities.
• It is also quite unrealistic that all investors have homogeneous expectations and that they all act rationally, based on the expected return and the standard deviation. Investors sometimes are affected by irrational behaviour, which does not let them make rational choices.
• CAPM is based on the returns in a single period.
• The CAPM assumes that there are no transaction costs, taxes and restrictions on short sales of any asset which is not true in the real world.
• The CAPM model is based on unrealistic assumptions such as existence of risk free assets. The CAPM assumes that the investor can borrow or lend unlimited funds at the risk free rate . In reality a risk-free asset does not exist. Even government bonds, which play this role in the practical usage of the CAPM actually contain risk as well

The Arbitrage pricing theory is designed to help overcome these weaknesses.

Q2: The two -stage model helps incorporate growth in different stages. Sometimes the growth is above a sustainable level. It allows the analyst to make use of expectations when growth might shift from high growth level to a more sustainable level. It can accomodate life - cycle effects.

While the constant growth model only considers the sustainable growth rate that exists from now to perpetuity , it does not consider growth rate that changes in multiple periods.

A weakness of all DDM is:

• The valuation of stock is highly sensitive to all the inputs like growth rate, required rate of return. Small changes in these inputs can cause large changes in the valuation of the stock . These inputs are also difficult to measure.
• The model also asserts that a company's stock price is highly sensitive  to the dividend growth rate chosen and the growth rate cannot exceed the cost of equity, which may not always be true.