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Capital Asset Pricing Model - Research Paper Example

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 The purpose of the paper “Capital Asset Pricing Model” is to understand the cost of equity of a given company. The cost of equity is associated with risk associated in investing in that company. Higher the risk associated in equity investment, higher will be the cost of equity for shareholders…
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Capital Asset Pricing Model
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Download file to see previous pages The average cost of capital in the S&P 500 is 10.2 percent. It can be said that the cost of capital of Nvidia is almost on par with S&P 500 companies. It is pertinent to note that risk free rate varies time to time depending upon the yield of government Treasury bill. Usually, it is found to give 3% in normal conditions and based on this treasury rate, the cost of equity can also be calculated using the same formula
Rj = RF + βj [RM - RF]
It is assumed that difference between the expectation on rate of return for market portfolio and available risk-free rate of return, [RM - RF] factor is 7.0
Then, Rj, the cost of equity = 3+ 1.54 [7]
                                            = 13.78
Based on this, the cost of capital of Nvidia is certainly higher than average cost of S&P 500 companies.
Answer 3.
The cost of equity of Chevron (CVX) can be calculated in the similar fashion.
Beta of Chevron is 0.70 (Key Statistics 2)
The cost of equity = 3+ 0.7 [7]   (Assuming risk free return of 3%)
                              = 7.9The cost of equity is remarkably low in case of Chevron compared to the average cost of S&P 500 companies.
It would be further interesting to find the cost of equity whose beta is 1.76 Wipro Ltd. (in NASDAQ known as WIP)
The cost of equity of Wipro = 3 + 1.76 [7]   (Key Statistics 3)
                                             = 15.32Thus, Wipro has higher cost of equity than Nvidia and Nvidia’s cost of equity is higher than Chevron. With rising beta the cost of equity also goes up. It can be described as a stock valuation model that takes into consideration dividends and their growth, discounted to present value....
in NASDAQ known as WIP) The cost of equity of Wipro = 3 + 1.76 [7] (Key Statistics 3) = 15.32 Thus, Wipro has higher cost of equity than Nvidia and Nvidia’s cost of equity is higher than Chevron. With rising beta the cost of equity also goes up. Answer 4. Dividend Growth Model It can be described as a stock valuation model that takes into consideration dividends and their growth, discounted to present value. Under this model, the valuation depends on 1. The Current Dividend 2. The Growth of Dividend at constant rate 3. Required Rate of Return For more clarity, it will be worthwhile to have some real life situation. The company is paying dividend of $2 per year and it is growing at the constant average rate of 3% per year. The only variable component in this model is required rate of return, if it is assumed as 15% Then, value under this model can be given as, Value= Current Dividend / (Required Return - Dividend Growth) (Gordon Growth…2011) = 2 / (0.15 – 0.03) = 2 / 0.12 = 16.66 Above calculation tells that under the given assumptions, this stock at the price of $16.66 should yield average annual 15% rate of return. At this juncture, it will also be prudent to look at the required rate of return and its basis. The required rate or return is given as the risk free return (such as U.S Treasury bill gives) adding to the return required for taking the risk in investing the stock. Thus, required rate (RR) is given as RR = risk free return + ? (RM-RF) = 3+ 1.7 (10-3) {Beta for the industry under calculation is 1.70} = 15 That is how required rate of return was assumed as 15% (Dividend Growth…) Arbitrage Pricing Theory – APT This theory was propounded by Stephen Ross in 1976. This theory has more flexible assumptions to describe as and taken as an alternative to ...Download file to see next pagesRead More
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