Capital Asset Pricing Model

Capital Asset Pricing Model

The basic assumption in the Dividend Growth Model is that the dividend is expected to grow at a constant rate. That this growth rate will not change for the duration of the evaluated period. As a result, this may skew the resultant for companies that are experiencing rapid growth. The Dividend Growth Model is better suited for those stable companies that fit the model. Those that are growing quickly or that don?t pay dividends do not fit the assumption parameters, and thus this model cannot be used. In this model, a company may not exceed the market growth rate. This paper critically evaluates the role of Capital Asset Pricing Model (CAPM) in modern portfolio management.

In addition, since the dividend growth rate is expected to remain constant indefinitely, the other measures of performance within the company are also expected to maintain the same growth rate. If in the current state, the dividend rate is greater that earnings, in time this model will show a dividend payout greater than the earnings of the company. Conversely, if earnings are growing faster than dividends, the payout rate will converge towards zero.

In summary, the Dividend Growth Model works well for those companies growing at a rate equal to or lower than that of the economy and have an established and stable dividend payout.

In order to estimate the cost of equity using the Dividend Growth Model, we simply adjust the model?s equation for estimating the price of a stock, given as such:P = D1 / (r ? g)Where P = the price of the stockD1 = the expected Dividend in one yearr = the required rate of returng = the expected Growth ConstantBy solving the equation for k we get the following:P(r ? g) = D1r ? g = D1 / Pr = (D1 / P) + gTherefore in order to estimate the cost of equity through the Dividend Growth Model, we simply add the constant growth rate and the projected dividend yield in one year.

The assumptions used in the Capital Asset Pricing Model (CAPM) are similar in that they assume an almost ?perfect world? scenario. Initially, CAPM assumes that all investors have the same rational expectations of returns, and that these returns are in line with the best prediction for future returns as based on the available information. It also makes the assumption that the dividends are paid normally, that assets are fixed, and that the market is efficient and in equilibrium with no inflation or change in the interest rate. CAPM additionally makes the important assumption that the evaluated stock is properly priced and that the risk level has been properly assessed.

Another major assumption is that there are no taxes, transaction fees, or arbitrage opportunities during the evaluation period. This is a huge assumption which is generally incorrect. Almost all transactions within the market have some sort of tax or fee associated with it.

Within CAPM, the required rate of return is found in the following equation:r = rf + ...