Risk and Return

Capital Asset Pricing Model

Introduction

The value of any investment depends primarily on 2 factors which are the expected net benefit and the required rate of return. When an investor experience with the decision to invest in a particular company or industry, they mostly look for the benefit and return.

Currently, there are three basic models through which RRR is calculated. All three methods have unique features for any company. This paper will focuses on the three models (dividend growth, CAPM, or APT) and which model is the best one for estimating the required rate of return (or discount rate) for the company. Based on the analysis and findings, one method will be recommended to the board of directors for the company

Discussion

The three methods are Dividend Discount Model (DDD), Capital Assets Pricing Model (CAPM) and Arbitrage Pricing Theory (APT).

Dividend Discount Model - (DDD)

Dividend Discount Model is best suited for income investors; it offers a simple approach to value the stock with the dividend growing at a stable rate. Moreover, if the value of the stock attained from the DDM is lower than what the share presently trading at, then the stock tends to be overvalued and vice versa. DDM has many variations and it is not good for that company that does not distribute dividends to their share holders. For instances, one deviation is the supernormal dividend growth model which take in to the consideration of high growth period followed by the lower constant growth period. The net present value of the cash flow is the main principle behind this model. In order to obtain the growth number, one way is to take the return on equity and multiply it by the retention ratio (Reilly, Frank K. et al., 2003).

There are two model of DDM which are

Gordon model: This is the simplest and most popular dividend discount models.

The two-step model (Two-stage model): To bypass the problem of excessive growth, some will prefer to do the evaluation procedure through this model.

In order to implement the DDM, it is necessary for the company to have

Expected dividends one year from now (D1)

The Dividend Growth Rate (GR)

Your required Rate of Return (RR)

Without these things, company cannot determine and implement this model in their company (Bruner, Eades, et al., 1998).

Capital Assets Pricing Model - CAPM

This model illustrates the relationship between the risk and expected return which is used in pricing the securities and stocks. The CAPM is a model which is used to measure financial assets, in order words it can be in this way that it is used to assess the profitability realized by a fund over a given period. In sum, CAPM is used to evaluate the price of risk for investors, that is to say, the expected return of a risky asset. The model is based on the assumption that investors seek to maximize their return on investment while minimizing their risk. The model fits into the general framework of markets in equilibrium. The CAPM allows, at least theoretically ...