Question

The cost of equity capital is the rate of return investors expect to receive from investing in the firm’s stock. There are two primary methods for determining the cost of equity. One approach is to use the Dividend Growth Model to determine the required rate of return on the firm’s equity. A second approach is to use the Capital Asset Pricing Model (CAPM) to determine the expected or required rate of return for a firm’s stock. Explain which you would use and why?

Answer 1

I would use both and take the average.

The DDM with constant growth gives cost of equity as:

rs = D1/P0+g, where P0 is the current price, D1 is the next expected dividend and g = constant growth rate in dividends.

The uncertainty in this method is the ascertainment of the growth rate which is difficult and would be in most cases unrealistic. However, this can be substituted with a different growth rate for a few initial years, which are predictable, and then, a constant growth rate for the rest of the years. Still prediction into the distant future is fraught with uncertainty.

The CAPM model rests on the theory that cost of capital is the required return on the security as determined by the compensation for the systematic risk that the security presents.

The measure of the systematic risk is the 'beta' of the security, which measures the relative movement of the security with the market return. The beta is supposed to indicate the extent to which systematic risk affects the security and for which the investor is to be compensated.

The compensation is risk free rate+beta*(market return-risk free rate).

The beta is based on past data which may not hold good in future. Further, it depends on the period selected and the number of periods for which data are analyzed.

But it gives the compensation for only the systematic risk attached to the security.

Hence, the average of the two measures would be ideal.