Estimating Weighted Average Cost of Equity Capital



Estimating Weighted Average Cost of Equity Capital

Introduction

The company chosen for this assignment is Vonage Holding Corporation. The method chosen among the three models is capital asset pricing model. The CAPM is a financing model used to evaluate the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the capital asset pricing model only reimburses investors for the systemic risk of the holding a portfolio since specific risk can be diversified away. Risk in the capital asset pricing model is assumed as wanting to be avoided but if risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk free return rate (Groppelli and Ehsan, 2006).

It should be noted, however, that the capital asset pricing model is valid under certain assumptions. First, as mentioned previously, this model assumes that investors are risk avoiders who want to maximize their wealth within the period. Specifically, the capital asset pricing model is a one period model.

The Capital Asset Pricing Model (CAPM) is the most popular model of the determination of expected returns on securities and other financial assets. It is considered to be an “asset pricing” model since, for a given exogenous expected payoff, the asset price can be backed out once the expected return is determined. Additionally, the expected return derived within the CAPM or any other asset pricing model may be used to discount future cash flows. These discounted cash flows then are added to determine an asset's price. So, even though the focus is on expected return, we will continue to refer to the CAPM as an asset pricing model.

Assumption of CAPM

The capital market theory is based on the basis of Markowitz's portfolio model. This theory is based on certain assumptions as:

a)All the investors are considered to be efficient investors who like to position themselves on the efficient frontier. Their exact location on the efficient frontier, however, depends on their risk return utility function.

b)Investors are free to borrow or lend any amount of money at the Risk- Free Rate of Return (RFR).

c)All investors are expected to have homogeneous expectations, i.e., their future rates of return have identical probability distributions.

d)All investors have same investment time horizon.

e)All investors are assumed to be infinitely divisible making it possible to even buy or sell fractional shares of any portfolio.

f)The process of buying or selling of assets does not involve any transaction costs. For example, holders of pension funds and even religious groups do not have to pay taxes and further it has been found out that the transaction cost of many financial instruments that are traded by most of the financial institutions are less than one percent.

g)It is assumed that the inflation rates are fully anticipated or in other situations it may be totally be absent thus ...