The Cost of Equity Capital and the CAPM - Essay Example

? The cost of equity capital and the CAPM s s Part I: Required rate of return is the minimum rate of return at which an individual will be inclined to put money in a particular security (Investopedia, 2013). A company should know its required rate of return to ascertain the benchmark return that it should provide its investors. If the actual return on a security is less than the required rate of return, the investors will sell the shares of that company and invest their funds elsewhere. Hence the concept of required rate of return in essential for a publically listed company. Determining a company's required rate of return can be a difficult task. We can use the following models to determine a company's required rate of return: 1) Dividend Discount Model: The dividend discount model is an example of a present value model of stock valuation in which dividends are used as stream of cash flows and the present value of the stream of dividends is defined as the value of the stock. The basic assumption of this model is that an investor who buys a share receives return only in the form of dividends. This assumption strictly holds for dividend paying stocks and for companies that are stable and pay a constant amount of dividend to its share holders. Companies that are categorized as high growth companies do not pay out dividends to their share holders since the excess funds are invested elsewhere in the business to exploit the existing growth opportunities (Madura, 2008). Hence DDM is not a suitable model to use for high growth companies that do not pay out dividends to its shareholders. Another assumption of the model is that there are no taxes and transaction costs. This is a false assumption since dividends earned are taxed in most of the countries. DDM is one of the oldest and easiest model to calculate a company's required rate of return. In DDM, analysts forecast the dividends that a company would pay to its shareholders along with the terminal share price over a finite horizon. To simplify the forecasting of dividends, it is assumed that the growth rate of dividends will remain constant. This is also called the Gordon Growth Model (CFA Institute, 2012). This again is a simplistic assumption and does not hold in many cases. The required rate of return is very sensitive to the inputs used in the DDM constant growth formula and hence the value of required rate of return is as good as the assumptions used by an analyst. DDM also assumes that the prices are efficient and the intrinsic value of a stock is equal to the market price of a stock. This assumption does not hold in equity market indices of developing markets. In conclusion, DDM is appropriate for valuing a company's required rate of return when its key assumption of steady future dividends hold. Most of the Equity market indices of developed markets satisfy this assumption. Lastly, an analyst should be aware of the fact that the output of the model is very sensitive to the inputs used and the model's accuracy largely depends on the assumptions used by an analyst. 2) Capital Asset Pricing Model (CAPM): CAPM is an equation that can be used to calculate the required rate of return of a stock. CAPM is one of the widest used models in finance to calculate the required rate of return because of its comparatively objective procedure of calculating a company's required rate of return (Jaffe, Westerfield, & Ross, 2005). Following equation can be used to calculate the required rate of return in CAPM: One of the assumptions of CAPM is that the shareholders are risk averse and they make the decision to invest in a stock based on the mean return and variance of returns of their total portfolio . This assumption does not hold in developing markets where investors are not very knowledgeable about the concepts of portfolio management. Another assumption of CAPM is that there are many investors in the market and all of those investors are price takers. This assumption does not hold true if the financial markets are not developed. Furthermore, CAPM also assumes that there are no transaction costs or taxes on equity. This is also an incorrect assumption since taxes are imposed on the returns earned from investing in stocks. CAPM also assumes that all investors can borrow or lend from the market at the risk free rate. This assumption is also false since the interest rates vary from investor to investor and are fairly different than the risk free rate. The CAPM does not hold true if some investors have more information than others and if the markets are not efficient. In the real world, many investors trade on the basis of insider information and hence this assumption is also fairly unrealistic. In conclusion, the underlying assumptions used by CAPM are fairly unrealistic. However, it is a better model than DDM to calculate the required rate of return since it can be applied to most of the stocks, whether dividend paying or non-dividend paying. 3) Arbitrage Pricing Theory (APT): Stephen Ross developed the APT model in 1976 as an alternative to the CAPM (Lumby & Jones, 2003). The APT model uses the asset's expected return and risk premium of number of risk premiums to calculate the required rate of return. APT is based on the assumption that a factor model describes the return on an asset and the number of factors is not specified. Another assumption of APT is that the asset-specific risk can be eliminated by an investor by creating a well diversified portfolio. APT also assumes that arbitrage opportunities does not exist among well diversified portfolios and the financial market is in equilibrium. Lastly, APT assumes that there are no taxes and transaction costs (Investopedia, 2013). APT uses less stringent assumptions than CAPM and hence is a better model to calculate the required rate of return of a stock. DDM is not an appropriate model to use for Cobalt International Energy since the company does not pay any dividends. The company's cash flows are not stable and hence not predicable and largely depend on the oil discoveries. The company does not have a stable growth rate and due to these reasons, DDM model cannot be used to calculate the company's required rate of return. I would suggest the use of APT to calculate the company's required rate of return since APT is a more realistic and hence a better model than CAPM. Most of the assumptions of CAPM does not hold true for Cobalt International Energy and hence the required rate of return will not be very accurate. This is why I suggest the board to use the APT model in determining Cobalt International Energy's required rate of return. Part II: According to CAPM: E(rj)= RRF + ?j (RM - RRF) Nike INC: 0.65+7.535 =8.185% Sony Corporation: 0.65+13.79 =14.44% McDonald's Corporation: 0.65+6.195 =6.845% Sony Corporation has the highest cost of equity of 14.44% based on CAPM. Sony has the highest cost of equity due to its high beta of 1.40 which represents that the return on Sony's stock is riskier than the market return. Moreover, Sony is listed on NYSE:SNE and this market has a relatively higher market return than other markets which is why the required return of Sony is on the higher side as compared to the stocks of Nike Inc. and McDonald's Corporation. Factors that influence Beta: Beta used in the CAPM is an important input in determining a company's required rate of return. Companies having high betas are generally riskier and hence investor's demand a higher required rate of return on such companies (Chisholm, 2009). There are many factors that influence a company's beta. For instance, a company having a high financial leverage (total liabilities to total assets ratio) will have a high beta since such a company is riskier than other low leveraged companies. Companies with high debt on their balance sheet will have to make high debt service payments each year whether they make profits or not and hence are riskier than low leveraged companies. Moreover, companies having high operating leverage i.e. they have high fixed costs are also riskier and hence have higher betas than companies that have relatively less fixed costs. Companies that are very cyclical are also very risky and have high betas since such companies outperform when the economy is doing well but under performs when the economy is in recession. This makes the returns on such companies very variable and highly risky. Thus, companies with high operating and financial leverage, and cyclicality of revenues have higher beta than companies having stable revenues and low operating and financial leverages. 2) Calculating cost of equity for a company is an important step in valuation Module 3 provides a good overview of different models that can be used to calculate a company's cost of equity along with their limitations and implications. I have learned the application of the dividend growth model and CAPM to estimate the required rate of return of a publically traded firm. I have also developed an understanding of the arbitrage pricing theory (APT) and can use that knowledge to explain the relationship of APT with CAPM and dividend growth models. Works Cited CFA Institute. (2012). Equity. Wiley and Sons. Chisholm, A. M. (2009). An Introduction to International Capital Markets: Products, Strategies, Participants. John Wiley & Sons. Investopedia. (2013). Arbitrage Pricing Theory - APT. Retrieved November 15, 2013, from Investopedia: http://www.investopedia.com/terms/a/apt.asp Investopedia. (2013). Required Rate Of Return - RRR. Retrieved November 15, 2013, from Investopedia: http://www.investopedia.com/terms/r/requiredrateofreturn.asp Jaffe, J., Westerfield, R., & Ross, R. (2005). Corporate Finance. Tata McGraw-Hill Education. Lumby, S., & Jones, C. (2003). Corporate Finance: Theory and Practice. Cengage Learning EMEA, 2003. Madura, J. (2008). Financial Institutions and Markets. Cengage Learning EMEA. Read More